SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Fiscal Year Ended December 31, 2017
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission File Number: 1-10777
Ambac Financial Group, Inc.
(Exact name of Registrant as specified in its charter)
(State of incorporation)
(I.R.S. employer identification no.)
One State Street Plaza, New York, New York
(Address of principal executive offices)
(Registrant’s telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x No ¨
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. Yes ¨ No x
Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III in this Form 10-K or any amendment to this Form 10-K. x
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See definition of “large accelerated filer”, “accelerated filer”, “smaller reporting company”and"emerging growth company" in Rule 12b-2 of the Exchange Act): (Check one):
Large accelerated filer
Smaller reporting company
Emerging growth company
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ¨ No x
Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Section 12, 13, or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes x No ¨
The aggregate market value of voting stock held by non-affiliates of the Registrant as of the close of business on June 30, 2017 was $785,107,730. As of February 27, 2018, there were 45,278,480 shares of Common Stock, par value $0.01 per share, were outstanding.
Documents Incorporated By Reference
Portions of the Registrant’s proxy statement for its 2018 annual meeting of stockholders are incorporated by reference in this Form 10-K in response to Part III Items 10, 11, 12, 13, and 14.
AMBAC FINANCIAL GROUP, INC. AND SUBSIDIARIES
TABLE OF CONTENTS
CAUTIONARY STATEMENT PURSUANT TO THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
In this Annual Report, we have included statements that may constitute “forward-looking statements” within the meaning of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Words such as “estimate,” “project,” “plan,” “believe,” “anticipate,” “intend,” “planned,” “potential” and similar expressions, or future or conditional verbs such as “will,” “should,” “would,” “could,” and “may,” or the negative of those expressions or verbs, identify forward-looking statements. We caution readers that these statements are not guarantees of future performance. Forward-looking statements are not historical facts but instead represent only our beliefs regarding future events, which may by their nature be inherently uncertain and some of which may be outside our control. These statements may relate to plans and objectives with respect to the future, among other things which may change. We are alerting you to the possibility that our actual results may differ, possibly materially, from the expected objectives or anticipated results that may be suggested, expressed or implied by these forward-looking statements. Important factors that could cause our results to differ, possibly materially, from those indicated in the forward-looking statements include, among others, those discussed under “Risk Factors” in Part I, Item 1A of this Annual Report on Form 10-K.
Any or all of management’s forward-looking statements here or in other publications may turn out to be incorrect and are based on management’s current belief or opinions. Ambac’s actual results may vary materially, and there are no guarantees about the performance of Ambac’s securities. Among events, risks, uncertainties or factors that could cause actual results to differ materially are: (1) the highly speculative nature of Ambac’s common stock and volatility in the price of Ambac’s common stock; (2) uncertainty concerning the Company’s ability to achieve value for holders of its securities, whether from Ambac Assurance Corporation ("Ambac Assurance) or from transactions or opportunities apart from Ambac Assurance; (3) adverse effects on Ambac’s share price resulting from future offerings of debt or equity securities that rank senior to Ambac’s common stock; (4) potential of rehabilitation proceedings against Ambac Assurance; (5) dilution of current shareholder value or adverse effects on Ambac’s share price resulting from the issuance of additional shares of common stock; (6) inadequacy of reserves established for losses and loss expenses and possibility that changes in loss reserves may result in further volatility of earnings or financial results; (7) decisions made by Ambac Assurance's primary insurance regulator for the benefit of policyholders that may result in material adverse consequences for holders of the Company’s securities or holders of securities issued or insured by Ambac Assurance; (8) increased fiscal stress experienced by issuers of public finance obligations or an increased incidence of Chapter 9 filings or other restructuring proceedings by public finance issuers; (9) failure to recover claims paid on Puerto Rico exposures or incurrence of losses in amounts higher than expected; (10) the Company’s inability to realize the expected recoveries included in its financial statements; (11) changes in Ambac Assurance’s estimated representation and warranty recoveries or loss reserves over time; (12) insufficiency or unavailability of collateral to pay secured obligations; (13) credit risk throughout the Company’s business, including but not limited to credit risk related to
residential mortgage-backed securities, student loan and other asset securitizations, collateralized loan obligations, public finance obligations and exposures to reinsurers; (14) credit risks related to large single risks, risk concentrations and correlated risks; (15) concentration and essentiality risk in connection with Military Housing insured debt; (16) the risk that the Company’s risk management policies and practices do not anticipate certain risks and/or the magnitude of potential for loss; (17) risks associated with adverse selection as the Company’s insured portfolio runs off; (18) adverse effects on operating results or the Company’s financial position resulting from measures taken to reduce risks in its insured portfolio; (19) intercompany disputes or disputes with Ambac Assurance's primary insurance regulator; (20) our inability to mitigate or remediate losses, commute or reduce insured exposures or achieve recoveries or investment objectives, or the failure of any transaction intended to accomplish one or more of these objectives to deliver anticipated results; (21) the Company’s substantial indebtedness could adversely affect its financial condition and operating flexibility; (22) the Company may not be able to obtain financing or raise capital on acceptable terms or at all due to its substantial indebtedness and financial condition; (23) restrictive covenants in agreements and instruments may impair the Company’s ability to pursue or achieve its business strategies; (24) loss of control rights in transactions for which we provide insurance due to a finding that Ambac Assurance has defaulted, whether due to the Segregated Account rehabilitation proceedings or otherwise; (25) the Company’s results of operation may be adversely affected by events or circumstances that result in the accelerated amortization of the Company’s insurance intangible asset; (26) adverse tax consequences or other costs resulting from the Segregated Account rehabilitation plan, or from the characterization of the Company’s surplus notes or other obligations as equity; (27) risks attendant to the change in composition of securities in the Company’s investment portfolio; (28) changes in tax law; (29) changes in prevailing interest rates; (30) changes on inter-bank lending rate reporting practices or the method pursuant to which LIBOR rates are determined; (31) factors that may influence the amount of installment premiums paid to the Company, including the Segregated Account rehabilitation proceedings; (32) default by one or more of Ambac Assurance's portfolio investments, insured issuers or counterparties; (33) market risks impacting assets in the Company’s investment portfolio or the value of our assets posted as collateral in respect of interest rate swap transactions; (34) risks relating to determinations of amounts of impairments taken on investments; (35) the risk of litigation and regulatory inquiries or investigations, and the risk of adverse outcomes in connection therewith, which could have a material adverse effect on the Company’s business, operations, financial position, profitability or cash flows; (36) actions of stakeholders whose interests are not aligned with broader interests of the Company's stockholders; (37) the Company’s inability to realize value from Ambac UK or other subsidiaries of Ambac Assurance; (38) system security risks; (39) market spreads and pricing on interest rate derivative insured or issued by the Company; (40) the risk of volatility in income and earnings, including volatility due to the application of fair value accounting; (41) changes in accounting principles or practices that may impact the Company’s reported financial results; (42) legislative and regulatory developments, including intervention by regulatory authorities; (43) the economic impact of “Brexit” may have an adverse effect on the Company’s insured international portfolio and the value of its foreign investments, both of which
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primarily reside with its subsidiary Ambac UK; (44) operational risks, including with respect to internal processes, risk and investment models, systems and employees, and failures in services or products provided by third parties; (45) the Company’s financial position that may prompt departures of key employees and may impact the Company’s ability to attract qualified executives and employees; (46) implementation of new tax legislation signed into law on December 22, 2017 (commonly known as the “Tax Cuts and Jobs Act”) may have unexpected consequences for the Company and the value of its securities, particularly its common shares; (47) implementation of the Tax Cuts and Jobs Act may negatively impact the economic recovery of Puerto Rico, which could result in higher loss severities or an extended moratorium on debt service owed on Ambac Assurance-insured bonds of Puerto Rico and its instrumentalities; (48) implementation of the Tax Cuts and Jobs Act could have a negative impact on municipal issuers of Ambac-insured bonds; and (49) other risks and uncertainties that have not been identified at this time.
Item 1. Business
Ambac Financial Group, Inc. (“Ambac,” "AFG" or the “Company”), headquartered in New York City, is a financial services holding company incorporated in the State of Delaware on April 29, 1991.
Ambac’s provides financial guarantee policies through its principal operating subsidiary, Ambac Assurance Corporation ("Ambac Assurance" or "AAC") and its wholly owned subsidiary Ambac Assurance UK Limited (“Ambac UK”), both of which have been in runoff since 2008. Ambac has another wholly-owned subsidiary, Everspan Financial Guarantee Corp. (“Everspan”), which has been in runoff since its acquisition in 1997. Insurance policies issued provide an unconditional and irrevocable guarantee which protects the holder of a debt obligation against non-payment when due of the principal and interest on the obligations guaranteed. Pursuant to such guarantees, Ambac Assurance and its subsidiaries make payments if the obligor responsible for making payments fails to do so when scheduled. Revenues from financial guarantees consist of: (i) premiums earned from insurance contracts, net of reinsurance, whether received upfront or on an installment basis and (ii) amendment and consent fees. Expenses from financial guarantees consist of: (i) loss and commutation payments for credit exposures; (ii) loss-related expenses, including those relating to the remediation of problem credits; and (iii) insurance intangible amortization.
Ambac Assurance has another wholly owned subsidiary, Ambac Credit Products LLC (“ACP”) that issued credit derivative contracts for which it collects fees over the contract term. Credit derivative contract terms are substantially similar to financial guarantee insurance. Credit derivatives also permit certain counterparties to assert mark-to-market termination claims under certain conditions; however, the assertion of such mark-to-market claims has been enjoined by the Second Amended Plan of Rehabilitation (as defined below) and orders of the Rehabilitation Court (as defined below). See discussion of “Ambac Assurance
Liquidity” in Part II, Item 7 included in this Form 10-K for further information.
Ambac Assurance and its subsidiaries have been working toward reducing uncertainties within its insured portfolio through active monitoring of key exposures such as municipal entities (including Puerto Rico), asset-backed securities (including residential mortgage-backed ("RMBS") and student loans) and municipal entities with stressed financial conditions. Additionally, Ambac Assurance and its subsidiaries are actively prosecuting legal claims (including RMBS related lawsuits), managing the regulatory framework applicable to the insurance entities, seeking to optimize capital allocation in a challenging environment that includes long duration obligations, and attempting to retain key employees.
The deterioration of the financial condition of Ambac Assurance and Ambac UK beginning in 2007 has prevented these companies from being able to write new business. An inability to write new business has and will continue to negatively impact Ambac’s future operations and financial results. Ambac Assurance’s ability to pay dividends and, as a result, Ambac’s liquidity, have been significantly restricted by the deterioration of Ambac Assurance’s financial condition and by regulatory, legal and contractual restrictions. It is highly unlikely that Ambac Assurance will be able to make dividend payments to Ambac for the foreseeable future. Refer to "Dividend Restrictions, Including Contractual Restrictions" below and Note 8. Insurance Regulatory Restrictions to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K, for more information on dividend payment restrictions.
Prior to the second quarter of 2017, Ambac had two reportable business segments: i) the financial guarantee segment, which consisted of financial guarantee insurance policies and credit derivative contracts and ii) the financial services segment which consisted of other financial products. In the second quarter of 2017, the Company began reporting financial guarantee as its only reportable business segment. Factors management took into consideration when eliminating the financial services segment included (i) significant swap commutations in June 2017, which left the remaining interest rate swaps and other interest rate derivatives as hedges against interest rate risk in the financial guarantee and investment portfolios, (ii) the maturity of the last investment agreement in March 2017, (iii) the immateriality of the remaining conduit transactions, and (iv) the appointment of a new Chief Executive Officer effective January 1, 2017. Management now reviews financial information, allocates resources and measures financial performance on a consolidated basis. All prior period amounts and disclosures have been adjusted to reflect the reportable segment change.
On May 1, 2013, Ambac emerged from Chapter 11 bankruptcy protection when the Second Modified Fifth Amended Plan of Reorganization became effective. Upon emergence Ambac had no outstanding debt at the holding company and significant net operating loss carry-forwards, of which $3.7 billion remain at December 31, 2017.
Interest Rate Derivatives:
Interest rate derivative transactions are executed through Ambac Financial Services (“AFS”), a wholly-owned subsidiary of Ambac Assurance. As noted above, the primary activities of AFS is to
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economically hedge interest rate risk in the financial guarantee and investment portfolios. Accordingly, these derivatives are positioned to benefit from rising rates. Under agreements governing the derivative positions, AFS generally must post collateral or margin in excess of the market value of the swaps and futures contracts. In addition, most of AFS’s counterparties currently possess the right to terminate their transactions with AFS and in the event of a rehabilitation of Ambac Assurance, some of AFS’s swaps could automatically terminate. A sudden termination of AFS’s derivatives, whether voluntarily or automatically, could result in losses. AFS has borrowed cash and securities from Ambac Assurance, to help support its collateral and margin posting requirements, previous termination payments and other cash needs.
Ambac derives interest rate derivative revenues from (i) changes in the fair value of the derivatives portfolio resulting from interest rate fluctuations and (ii) the value of future contract terminations or settlements which may differ from the carrying value of the those contracts.
Credit risks relating to derivative positions primarily concern the default of a counterparty. Ambac's interest rate derivatives generally consist of centrally cleared swaps, US treasury futures and some over-the-counter ("OTC") swaps with financial guarantee customers or bank counterparties. Counterparty default exposure is mitigated through the use of industry standard collateral posting agreements or margin posting requirements. Cleared swaps, futures and OTC derivatives with bank counterparties require margin or collateral to be posted up to or in excess of the market value of the derivatives. Derivative contracts entered into with financial guarantee customers are not subject to collateral posting agreements. Credit risk associated with such customer derivatives, including credit derivatives, is managed through the risk management processes described in the Risk Management Group section below. In some cases, derivatives between Ambac and financial guarantee customers are placed through a third party financial intermediary and similarly do not require collateral posting.
AFS manages a variety of market risks inherent in its businesses, including credit, market, liquidity, operational and legal. These risks are identified, measured, and monitored through a variety of control mechanisms, which are in place at different levels throughout the organization. See “Quantitative and Qualitative Disclosures About Market Risk” included in Part II, Item 7A in this Form 10-K for further information.
Ambac Assurance issued investment agreements to structured finance and municipal issuers through its wholly-owned subsidiary, Ambac Capital Funding. Investment agreements were customized for each investor to provide guaranteed interest and return of principal in accordance with their requirements. Each investment agreement was insured by Ambac Assurance through a financial guarantee insurance policy. The last investment agreement matured in March 2017.
A subsidiary of Ambac previously transferred financial assets to two special purpose entities. The business purpose of these entities was to provide certain financial guarantee clients with funding for
their debt obligations. The activities of the special purpose entities are contractually limited to purchasing assets from Ambac, issuing medium-term notes (“MTNs”) to fund such purchases, executing derivative hedges and obtaining financial guarantee policies with respect to indebtedness incurred. As of December 31, 2017, Ambac Assurance or Ambac UK had financial guarantee insurance policies issued for all assets, MTNs and derivative contracts owned and outstanding by the entities. Ambac does not consolidate these entities under the relevant accounting guidance for consolidation of variable interest entities. See Note 2. Basis of Presentation and Significant Accounting Policies and Note 3. Special Purpose Entities, Including Variable Interest Entities to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K for further information.
In February 2018, Ambac achieved one of its key strategic strategies, the exit from rehabilitation of Ambac Assurance’s Segregated Account (as defined below). Having accomplished this milestone, Ambac will continue to pursue and prioritize its remaining key strategic priorities, namely:
Active runoff of Ambac Assurance and its subsidiaries through transaction terminations, policy commutations, settlements and restructurings, with a focus on our watch list credits and known and potential future adversely classified credits, that we believe will improve our risk profile, and maximizing the risk-adjusted return on invested assets;
Ongoing rationalization of Ambac's and its subsidiaries' capital and liability structures;
Loss recovery through active litigation management and exercise of contractual and legal rights;
Ongoing review of organizational effectiveness and efficiency of the operating platform; and
Evaluation of opportunities in certain business sectors that meet acceptable criteria that will generate long-term stockholder value with attractive risk-adjusted returns.
With respect to our new business strategy, we have identified certain business sectors adjacent to Ambac's core business, in which future opportunities will be evaluated. The evaluation will be conducted through a measured and disciplined approach to identify opportunities that are synergistic to Ambac, match Ambac's core competencies, are rapidly scalable or available through mergers and acquisitions and that may allow for the utilization of Ambac's net operating loss carry-forwards. Although we are exploring new business opportunities for Ambac, no assurance can be given that we will be able to execute and/or obtain the financial and other resources that may be required to finance the acquisition or development of any new businesses or assets. Due to these factors, as well as uncertainties relating to the ability of Ambac Assurance to deliver value to Ambac, the value of our securities remains speculative.
The execution of Ambac’s strategy to increase the value of its investment in Ambac Assurance is subject to the restrictions set forth in the Settlement Agreement, dated as of June 7, 2010 (the "Settlement Agreement"), by and among Ambac Assurance, ACP, Ambac and certain counterparties to credit default swaps with ACP
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that were guaranteed by Ambac Assurance, as well as the Stipulation and Order (as defined in Note 1. Background and Business Description to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K), each of which requires OCI (and in the case of the Settlement Agreement, under certain circumstances, holders of surplus notes issued pursuant to the Settlement Agreement) to approve certain actions taken by or in respect of Ambac Assurance. In exercising its rights under the Stipulation and Order or Settlement Agreement, OCI will act for the benefit of policyholders, and will not take into account the interests of Ambac. See Note 1. Background and Business Description to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K for further information.
Opportunities for remediating losses on poorly performing insured transactions also depend on market conditions, including the perception of Ambac Assurance’s creditworthiness, the structure of the underlying risk and associated policy as well as other counterparty specific factors. Ambac Assurance's ability to commute policies or purchase certain investments may also be limited by available liquidity.
In March 2010, Ambac Assurance established a segregated account pursuant to Wisconsin Stat. §611.24(2) (the “Segregated Account”) to segregate certain segments of Ambac Assurance’s liabilities. The Office of the Commissioner of Insurance for the State of Wisconsin (“OCI” (which term shall be understood to refer to such office as regulator of Ambac Assurance and to refer to the Commissioner of Insurance for the State of Wisconsin as rehabilitator of the Segregated Account (the “Rehabilitator”), as the context requires)) commenced rehabilitation proceedings in the Wisconsin Circuit Court for Dane County (the “Rehabilitation Court”) with respect to the Segregated Account (the “Segregated Account Rehabilitation Proceedings”) in order to permit OCI to facilitate an orderly run-off and/or settlement of the liabilities allocated to the Segregated Account pursuant to the provisions of the Wisconsin Insurers Rehabilitation and Liquidation Act. Ambac Assurance is not, itself, in rehabilitation proceedings.
On October 8, 2010, OCI filed a plan of rehabilitation for the Segregated Account (the "Segregated Account Rehabilitation Plan") in the Rehabilitation Court. The Rehabilitation Court confirmed the Segregated Account Rehabilitation Plan on January 24, 2011. On June 11, 2014, the Rehabilitation Court approved amendments to the Segregated Account Rehabilitation Plan and the Segregated Account Rehabilitation Plan, as amended, became effective on June 12, 2014.
On September 25, 2017 the Rehabilitator filed a motion in the Rehabilitation Court seeking entry of an order approving an amendment to the Segregated Account Rehabilitation Plan (the "Second Amended Plan of Rehabilitation"). Following the conclusion of a Confirmation Hearing on January 22, 2018, the Rehabilitation Court entered an order granting the Rehabilitator's motion and confirming the Second Amended Plan of Rehabilitation. On February 12, 2018 (the "Effective Date"), the Second Amended Plan of Rehabilitation became effective. Consequently, the rehabilitation of the Segregated Account was concluded. Refer to Note 1. Background and Business Description to the Consolidated Financial Statements included in Part II, Item 8
in this Form 10-K, for more information on the Segregated Account and the Segregated Account Rehabilitation Proceedings.
Enterprise Risk Management
The Company's policies and procedures relating to risk assessment and risk management are overseen by its Board of Directors. The Board takes an enterprise-wide approach to risk management oversight that is designed to support the Company's business plans at a reasonable level of risk. A fundamental part of risk assessment and risk management is not only understanding the risks the Company faces and what steps management is taking to manage those risks, but also understanding what level of risk is appropriate for the Company. The Board of Directors annually reviews the Company's business plan, factoring risk management into account. It also approves the Company's risk appetite statements, which articulate the Company's tolerance for certain risks and describes the general types of risk that the Company accepts, within certain parameters, or attempts to avoid.
While the Board of Directors has the ultimate oversight responsibility for the risk management process, various committees of the Board also have responsibilities related to risk assessment and risk management, and management has responsibility for managing the risks to which the Company is exposed and reporting on such matters to the Board of Directors and applicable Board committees.
The Audit Committee oversees the management of risks associated with the integrity of Ambac’s financial statements and its compliance with legal and regulatory requirements. In addition, the Audit Committee discusses policies with respect to risk assessment and risk management, including major financial risk exposures and the steps management has taken to monitor and control such exposures. The Audit Committee reviews with management, internal auditors, and external auditors Ambac's accounting policies, Ambac's system of internal controls over financial reporting and the quality and appropriateness of disclosure and content in the financial statements and other external financial communications.
The Compensation Committee oversees the management of risk primarily associated with our ability to attract, motivate and retain quality talent, particularly executive talent, compensation structures that might lead to undue risk taking, and disclosure of our executive compensation philosophies, strategies and activities.
The Governance and Nominating Committee oversees the management of risk primarily associated with Ambac’s ability to attract and retain quality directors, Ambac’s corporate governance programs and practices and our compliance therewith. Additionally, the Governance and Nominating Committee oversees the processes for evaluation of the performance of the Board, its committees and management each year and considers risk management effectiveness as part of its evaluation. The Governance and Nominating Committee also performs oversight of the business ethics and compliance program, and reviews compliance with Ambac’s Code of Business Conduct.
The Strategy and Risk Policy Committee oversees the management of risk and risk appetite primarily with respect to strategic plans and initiatives, oversight of Ambac’s capital
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structure, financing and treasury matters and oversight of management's process for the identification, evaluation and mitigation of Ambac’s financial and commercial-related risks.
The full Board also receives quarterly updates from Board committees, and the Board provides guidance to individual committee activities as appropriate.
In order to assist the board of directors in overseeing Ambac’s risk management, Ambac uses enterprise risk management, a company-wide process that involves the Board of Directors, management and other personnel in an integrated effort to identify, assess and manage a broad range of risks (e.g., credit, financial, legal, liquidity, market, model, operational, regulatory and strategic), that may affect the Company’s ability to execute on its corporate strategy and fulfill its business objectives. The Enterprise Risk Committee (“ERC”), which is a management committee, is comprised of senior level management responsible for assisting in the management of the Company’s risks on an individual and aggregate basis. The ERC produces the relevant risk management information for senior management, the Board of Directors and applicable Board committees.
Ambac management has established other committees to assist in managing the risks embedded in the enterprise. These committees will meet monthly or as needed on an ad hoc basis.
The Asset Liability Management Committee's (“ALCO”) objective is to foster an enterprise wide culture and approach to liquidity management, asset management, asset valuation and hedging. Members of ALCO include the Chief Executive Officer, Chief Financial Officer and senior managers from investment management and the Risk Management Group.
The Risk Committee's objective is establish an interdisciplinary team of professionals from different parts of the company to provide oversight of the key risk remediation issues impacting Ambac. The purview of the committee is to review and approve risk remediation activities for the financial guarantee insured portfolio as well as review changes to Ambac's adversely classified, survey and watch list credits (as defined in Note 2. Basis of Presentation and Significant Accounting Policies). This committee was established in the fourth quarter of 2017. Previously, most risk remediation activities were approved by ALCO. Members of the Risk Committee include the Chief Executive Officer, Head of Risk Management, Chief Financial Officer and senior managers from throughout risk, corporate services group, operations, investment management, legal and finance.
Our Internet address is www.ambac.com. We make available free of charge, through the investor relations section of our web site, annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and any amendments to those reports, filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as well as proxy statements, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the U.S. Securities and Exchange Commission. Our Investor Relations Department can be contacted at Ambac Financial Group, Inc., One
State Street Plaza, New York, New York 10004, Attn: Investor Relations, telephone: 212-208-3222 email: email@example.com. The reference to our website address does not constitute inclusion or incorporation by reference of the information contained on our website in this Form 10-K or other filings with the SEC, and the information contained on our website is not part of this document.
RISK MANAGEMENT GROUP
Financial guarantee insurance and credit derivatives ("financial guarantees") were sold in three principal markets: U.S. public finance, U.S. structured finance and international finance. Ambac’s financial guarantee insurance policies and credit derivative contracts expose the Company to the direct credit risk of the assets and/or obligor supporting the guaranteed obligation. In addition, insured transactions expose Ambac to indirect risks that may increase our overall risk, such as credit risk separate from, but correlated with, our direct credit risk, market, model, economic, natural disaster and mortality or other non-credit type risks. Please refer to Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Financial Guarantees in Force” section below for details on the financial guarantee insured portfolio.
The Risk Management Group is primarily responsible for the development, implementation and oversight of loss mitigation strategies, surveillance and remediation of the insured financial guarantee portfolio (including through the pursuit of recoveries in respect of paid claims and commutations of policies). Our ability to execute certain risk management activities may be limited by the restrictions set forth in the Settlement Agreement and the Stipulation and Order. See Note 1. Background and Business Description to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K for further information.
Ambac’s Risk Management Group ("RMG") has an organizational structure designed around four primary areas of focus: Surveillance, Risk Remediation, Credit Risk Management and Loss Reserving and Analytics. The Head of Risk Management reports directly to Ambac's Chief Executive Officer and regularly informs and updates the Audit Committees of the Boards of Directors of Ambac and Ambac Assurance with respect to risk-related topics in the insured portfolio.
This group's focus is on the early identification of potential stress or deterioration in connection with exposures in the insured portfolio and the related credit analysis associated with these and other insured portfolio exposures.
Analysts in this group perform periodic credit reviews of insured exposures according to a schedule based on the risk profile of the guaranteed obligations or as necessitated by specific credit events or other macro-economic variables. Risk-adjusted surveillance strategies have been developed for each bond type with review periods and scope of review based upon each bond type’s risk profile. The risk profile is assessed regularly in response to our own experience and judgments or external factors such as the economic environment and industry trends. In general, surveillance activities are designed to detect deterioration in credit quality or changes in the economic, regulatory or political environment which could adversely impact the portfolio. Active surveillance enables analysts
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to track single credit migration and industry credit and performance trends.
The focus of a related credit review is to assess performance, identify credit trends and recommend appropriate credit classifications, ratings and changes to a transaction or bond type’s review period and surveillance requirements. Please refer to Note 2. Basis of Presentation and Significant Accounting Policies to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K for further discussion of the various credit classifications. If a problem is detected, the Surveillance group will then work with the Risk Remediation group on a loss mitigation plan, as necessary.
Surveillance for collateral dependent transactions, including, but not limited to, residential mortgage-backed securities (“RMBS”), asset-backed securities (“ABS”) and student loan transactions, focuses on reviews of the underlying asset cash flows and, if applicable, the performance of servicers or collateral managers. Ambac Assurance generally receives periodic reporting of transaction performance from issuers or trustees. Surveillance analysts review these reports to monitor performance and, if necessary, seek legal advice to ensure that reporting and application of cash flows comply with transaction requirements.
This group’s focus is on risk remediation, loss mitigation and restructuring related to the insured portfolio of Ambac Assurance.
Risk remediation helps to reduce exposure to credits that are developing, have the potential for future adverse development or are already adversely classified by, among other things, securing rights and remedies, both of which help to mitigate losses in the event of further deterioration or event of default, or, as available, working with an issuer to refinance or retire debt.
Loss mitigation focuses on the analysis, implementation and execution of commutation and related claims reduction or defeasance strategies for policies with potential future claims. Loss mitigation prioritizes policies, or portions thereof, for commutation, refinancing or other claims reduction or defeasance strategies.
Restructuring or workout is the focused and active process of minimizing claims and maximizing recoveries typically following an event of default. The emphasis on reducing risk is centered on reducing enterprise-wide exposure on a prioritized basis.
For certain adversely classified, survey list and watch list credits, Risk Remediation analysts will develop and implement a remediation or loss mitigation plan that could include actions such as working with the issuer, trustee, bond counsel, servicer and other interested parties in an attempt to remediate the problem and minimize Ambac Assurance’s exposure to potential loss. Other actions could include working with bond holders and other economic stakeholders to negotiate, structure and execute solutions, such as commutations.
Adversely classified, survey list and watch list credits are tracked closely by Surveillance analysts together with Risk Remediation analysts as part of the Risk Remediation process and discussed at regularly scheduled meetings with Credit Risk Management (see discussion following in “Credit Risk Management”) and the Risk Committee (see discussion following in "Risk Committee"). In some cases, Risk Remediation will engage restructuring or workout
experts, attorneys and/or other consultants with appropriate expertise in the targeted loss mitigation area to assist management in examining the underlying contracts or collateral, providing industry specific advice and/or executing strategies.
In Risk Remediation, we have established cross-functional teams in key areas of focus, comprised of personnel both within the RMG and in other departments, to target proactive mitigation and remediation of losses and potential future losses associated with certain credits and sectors in the insured portfolio. Examples of such efforts include teams of professionals focused on (i) the review and enforcement of contractual representations and warranties in RMBS policies, (ii) RMBS servicing and (iii) the analysis and prioritization of policies with projected claims or the potential for future material adverse development to target and execute risk reduction, restructuring and commutation strategies. Members of these cross-functional teams will often work with external experts in the pursuit of risk reduction efforts.
For RMBS servicing, the team focuses on servicer oversight and remediation. Analysts monitor the performance of servicers through a combination of (i) regular reviews of servicer performance; (ii) compliance certificates received from servicer management; (iii) independent rating agency information; (iv) reviews of servicer financial information; and (v) onsite servicing diligence.
In some transactions, Ambac Assurance has the right to direct a transfer of RMBS and other servicing to an alternative servicer, upon certain events and subject to certain conditions. The decision to exercise this right is made based on various factors, including an assessment of the performance of the existing servicer and an assessment of whether a transfer of servicing may improve the performance of the collateral and reduce risk to Ambac Assurance. In the case of RMBS, Ambac Assurance has developed relationships with preferred servicers. Preferred servicers are selected through a formalized servicer review process that determines, among other key factors, the servicer’s ability and willingness to actively implement intense and proven loss mitigation activities on RMBS. Ambac Assurance may decide to exercise its rights to direct the transfer of servicing to a preferred servicer where such rights are available. The transfer of servicing is done with the objectives of (i) minimizing losses and distress levels by deploying targeted and enhanced loss mitigation programs; (ii) increasing visibility to Ambac Assurance of all servicing activities that impact overall deal performance; (iii) better aligning the servicer’s financial interest to the performance of the underlying deal through the utilization of performance based incentives; and (iv) reducing the risk of servicer underperformance due to servicer financial difficulty.
Ambac Assurance believes that the loss mitigation activities, alignment of interests and close monitoring of servicers constitute credible means of minimizing risks and losses related to insured RMBS.
A team of professionals is focused on recoveries from sponsors where Ambac Assurance believes material breaches of representations and warranties have occurred with respect to certain RMBS policies. The team engages with experienced consultants to perform the re-underwriting of loan files and consults with internal and external legal counsel with regard to loan putbacks as well as settlement and litigation strategies (refer to Note 2. Basis of Presentation and Significant Accounting Policies and Note 7. Financial Guarantee Insurance Contracts to the Consolidated
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Financial Statements included in Part II, Item 8 in this Form 10-K for further discussion on this topic).
Loss Reserving and Analytics ("LRA")
LRA manages the quarterly loss reserving process for insured portfolio credits with projected policy claims. It also supports the development, operation and/or maintenance of various analytical models used in the loss reserving process as well as in other risk management functions. LRA works with Surveillance and Risk Remediation analysts responsible for a particular credit on the development, review and implementation of loss reserve scenarios and related analysis.
Credit Risk Management ("CRM")
CRM manages the decision process for all material matters that affect credit exposures within the insured portfolio. While not responsible for the credit analysis or execution of risk remediation or loss mitigation strategies, CRM provides a forum for independent assessments, reviews and approvals and drives consistency and timeliness. The scope of credit matters under the purview of CRM includes material amendments, waivers and consents, evaluation of remediation or loss mitigation plans, credit review scheduling, adverse credit classification and below investment grade rating designations, adversely classified credit reviews, sector reviews and overall portfolio review.
The CRM decision process may involve a review of structural, legal, political and credit issues and also includes determining the proper level of approval, which varies based on the nature and materiality of the matter. In particular, formal plans or transactions that relate to risk remediation, loss mitigation or restructuring may also require Risk Committee approval. In addition, such plans or transactions that have material asset liquidity implications may also require ALCO approval.
In structured transactions, including structured public finance transactions, Ambac Assurance often is the control party as a result of insuring the transaction’s senior class or tranche. The control party may direct specified parties, usually the trustee, to take or not take certain actions following contractual defaults or trigger events. Control rights and the scope of direction and remedies vary considerably among our insured transactions. Because Ambac Assurance is party to and/or has certain rights in documents supporting transactions in the insured portfolio, Ambac Assurance frequently receives requests for amendments, waivers and consents (“AWCs”). Ambac Assurance’s risk management personnel review, analyze and process all requests for AWCs. As a part of the Segregated Account Rehabilitation Proceedings, the Rehabilitation Court enjoined certain actions by other parties to preserve Ambac Assurance’s control rights that could otherwise have lapsed or been compromised. By way of the Second Amended Plan of Rehabilitation and orders of the Rehabilitation Court, such protections are intended to be continued after the consummation of the Rehabilitation Exit Transactions (as defined in Note 1. Background and Business Description to the Consolidated Financial Statements, included in Part II, Item 8 in this Form 10-K).
Adversely Classified Credit Review
Credits that are either in default or have developed problems that eventually may lead to a default are tracked closely by the appropriate Surveillance and Risk Remediation teams and discussed
at meetings with CRM. Adversely classified credit meetings include members of CRM, Surveillance, Risk Remediation and legal, as necessary. As part of the review, relevant information, along with the plan for corrective actions and a reassessment of the credit’s rating and credit classification is considered. Internal and/or external counsel generally review the documents underlying any problem credit and, if applicable, an analysis is prepared outlining Ambac Assurance’s rights and potential remedies, the duties of all parties involved and recommendations for corrective actions. Ambac Assurance also meets with relevant parties to the transaction as necessary. The review schedule for adversely classified credits is tailored to the remediation plan to track and prompt timely action and proper internal and external resourcing. A summary of developments regarding adversely classified credits and credit trends is also provided to the Credit Committee and Ambac’s and Ambac Assurance’s Board of Directors no less than quarterly.
The insured portfolio contains exposures that are correlated and/or concentrated. Risk Management's surveillance includes identifying these types of exposures and identifying the risks that would or could trigger credit deterioration across the related exposures. When such risks occur, adverse credit classification may be warranted across many of the correlated and/or concentrated exposures. This is the case with student loans and RMBS, for example, which have several correlations including those associated with consumer lending, unemployment and home prices. In the past, our not-for-profit healthcare and our leveraged lease exposures experienced periods of stress arising from their concentrated and/or correlated risks, when there were major changes to healthcare reimbursement programs especially Medicaid, or significant weakness in consumer and business travel, in the case of the former and the latter, respectively. In the future, Ambac’s portfolio may be subject to similar credit deterioration arising from concentrated and/or correlated risks. Examples of other such risks that could impact our portfolio, and that our surveillance is designed to monitor include the impact of potential municipal bankruptcy contagion, the impact of tax reform on state and municipal bond issuers, or the impact of large scale domestic military cutbacks on our military housing portfolio or event risk such as natural disasters or other regional stresses. Most such risks cannot be predicted, and may materialize unexpectedly or develop rapidly. Although our surveillance allows us to connect the event and stress to the related exposures and assign an adverse credit classification and estimate losses across the affected credits, when necessary, we may not have adequate resources or contractual rights and remedies to mitigate loss arising from such risks.
Amendment, Waiver and Consent Review / Approval
The decision to approve or reject AWCs is based upon certain credit factors, such as the issuer’s ability to repay the bonds and the bond’s security features and structure. Members of Ambac Assurance’s Surveillance group review, analyze and process all requests for AWCs. All AWCs are initially screened for materiality in the Surveillance group. Non-material AWCs require the approval of at least the Surveillance analyst and the Surveillance manager. Material AWCs are within the purview of CRM, as noted above. For material AWCs, CRM has established minimum requirements that may be modified to require more or varied approvals depending upon the matter’s complexity, size or other characteristics.
Ambac Assurance assigns internal credit ratings to individual exposures as part of the AWC process and at surveillance reviews. These internal credit ratings, which represent Ambac Assurance’s
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independent judgments, are based upon underlying credit parameters consistent with the exposure type.
The Risk Committee is a management committee that was established in the fourth quarter of 2017, as an interdisciplinary body of expertise from different parts of the Ambac Assurance to provide oversight of the key risk remediation, loss mitigation and restructuring issues (collectively "risk remediation") impacting the Company. The committee comprises the CEO, CFO, Head of Risk Management, as chair, General Counsel, and other key personnel from the Risk Management, Finance, Corporate Services and Legal departments.
The mission of the committee is to: (i) to enhance, improve and standardize the key impact metrics, including economic, financial, and strategic, considered when making risk remediation decisions; (ii) to ensure a timely, rigorous and thorough approach to risk remediation at Ambac Assurance and the prudent and economically accretive use of capital in support of these activities; and (iii) to enhance enterprise-wide communication and cooperation in connection with these core Ambac Assurance business strategies.
The purpose of the Risk Committee is to: (i) to review on a periodic basis changes to Ambac Assurance internal credit classifications and ratings of adversely classified credits, survey list credits, and watch list credits after the aforementioned CRM process; (ii) to review and approve risk remediation plans for adversely classified credits, survey list credits and watch list credits; (iii) to provide oversight and to review new risk remediation structures or approaches in connection with risk remediation plans or anticipated transactions; (iv) to review and approve proposed risk remediation transactions whereby Ambac Assurance is making an economic contribution; and (iv) other such risk remediation activities that Ambac Assurance may delegate to the Risk Committee.
INSURANCE REGULATORY MATTERS AND OTHER RESTRICTIONS
Ambac Assurance and Everspan are domiciled in the State of Wisconsin and, as such, are subject to the insurance laws and regulations of the State of Wisconsin (the “Wisconsin Insurance Laws”) and are regulated by the OCI. In addition, Ambac Assurance and Everspan are subject to the insurance laws and regulations of the other jurisdictions in which they are licensed. See Note 8. Insurance Regulatory Restrictions to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K for further information on regulatory restrictions.
In addition, pursuant to the terms of the Settlement Agreement and the Stipulation and Order, Ambac Assurance must seek prior approval by OCI of certain corporate actions. The Settlement Agreement and Stipulation and Order include covenants which restrict the operations of Ambac Assurance. The Settlement Agreement will remain in force until the surplus notes issued thereunder have been redeemed, repurchased or repaid in full. The Stipulation and Order will remain in force for so long as OCI determines it to be necessary. Certain of the restrictions in the Settlement Agreement may be waived with the approval of the OCI and/or the requisite percentage of holders of surplus notes issued thereunder.
The Prudential Regulatory Authority ("PRA") and Financial Conduct Authority ("FCA") (and their predecessor regulator the Financial Services Authority (“FSA”)) have exercised significant oversight of Ambac UK since 2008, after Ambac, Ambac Assurance and Ambac UK began experiencing financial stress. In 2009, Ambac UK’s license to write new business was curtailed by the FSA and the insurance license was limited to undertaking only run-off related activity. As such, Ambac UK is authorized to run-off its insurance portfolio in the United Kingdom, and to do the same through a branch in Milan, Italy, and a number of other EU countries. EU legislation has allowed Ambac UK to conduct business in EU states other than the United Kingdom through a “passporting” arrangement, which eliminates the necessity of additional licensing or authorization in those other EU jurisdictions. See Note 8. Insurance Regulatory Restrictions to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K for further information on regulatory restrictions.
Regulations over change in control
Under Wisconsin law applicable to insurance holding companies, any acquisition of control of Ambac, and any other direct or indirect control of Ambac Assurance and Everspan, requires the prior approval of the OCI. “Control” is defined as the direct or indirect power to direct or cause the direction of the management and policies of a person. Any purchaser of 10% or more of the outstanding voting stock of a corporation is presumed to have acquired control of that corporation and its subsidiaries unless the OCI, upon application, determines otherwise. For purposes of this test, Ambac believes that a holder of common stock having the right to cast 10% or more of the votes which may be cast by the holders of all shares of common stock of Ambac would be deemed to have control of Ambac Assurance and Everspan within the meaning of the Wisconsin Insurance Laws. The United Kingdom has similar requirements applicable in respect of Ambac, as the ultimate holding company of Ambac UK.
Common Stock Restrictions
Ambac’s Amended and Restated Certificate of Incorporation limits voting and transfer rights of stockholders in significant ways. Article IV contains voting restrictions applicable to any person owning at least 10% of Ambac’s common stock so that such person (including any group consisting of such person and any other person with whom such person or any affiliate or associate of such person has any agreement, contract, arrangement or understanding with respect to acquiring, voting, holding or disposing of Ambac’s common stock) shall not be entitled to cast votes in excess of one vote less than 10% of the votes entitled to be cast by all common stock holders, except as otherwise approved by OCI.
There are substantial restrictions on the ability to transfer Ambac’s common stock set forth in Article XII of Ambac’s Amended and Restated Certificate of Incorporation. In order to preserve certain tax benefits, subject to limited exceptions, any attempted transfer of common stock shall be prohibited and void to the extent that, as a result of such transfer (or any series of transfers of which such transfer is a part), either (i) any person or group of persons shall become a holder of 5% or more of the Company’s common stock or (ii) the percentage stock ownership interest in Ambac of any holder of 5% or more of the Company’s common stock shall be increased (a “Prohibited Transfer”). These restrictions shall not apply to an attempted transfer if the transferor or the transferee
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obtains the written approval of Ambac’s Board of Directors to such transfer. A purported transferee of a Prohibited Transfer shall not be recognized as a stockholder of Ambac for any purpose whatsoever in respect of the securities which are the subject of the Prohibited Transfer (the “Excess Securities”). Until the Excess Securities are acquired by another person in a transfer that is not a Prohibited Transfer, the purported transferee of a Prohibited Transfer shall not be entitled with respect to such Excess Securities to any rights of stockholders of Ambac, including, without limitation, the right to vote such Excess Securities and to receive dividends or distributions, whether liquidating or otherwise, in respect thereof, if any. Once the Excess Securities have been acquired in a transfer that is not a Prohibited Transfer, the securities shall cease to be Excess Securities. If the Board determines that a transfer of securities constitutes a Prohibited Transfer then, upon written demand by Ambac, the purported transferee shall transfer or cause to be transferred any certificate or other evidence of ownership of the Excess Securities within the purported transferee’s possession or control, together with any distributions paid by Ambac with respect to such Excess Securities, to an agent designated by Ambac. Such agent shall thereafter sell such Excess Securities and the proceeds of such sale shall be distributed as set forth in the Amended and Restated Certificate of Incorporation. If the purported transferee of a Prohibited Transfer has resold the Excess Securities before receiving such demand, such person shall be deemed to have sold the Excess Securities to Ambac’s agent and shall be required to transfer to such agent the proceeds of such sale, which shall be distributed as set forth in the Amended and Restated Certificate of Incorporation.
Dividend Restrictions, Including Contractual Restrictions
Due to contractual and regulatory restrictions, Ambac Assurance has been unable to pay common dividends to Ambac since 2008 and will be unable to pay common dividends in 2018 without certain approvals, including the prior consent of the OCI, which is unlikely. Ambac Assurance’s ability to pay dividends is further restricted by the Settlement Agreement, the Stipulation and Order and the terms of its Auction Market Preferred Shares ("AMPS"). See Note 8. Insurance Regulatory Restrictions to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K for further information on dividends.
As a result of these restrictions, Ambac Assurance is not expected to pay dividends to Ambac for the foreseeable future.
Ambac UK is not expected to pay any dividends to Ambac Assurance for the foreseeable future. While the UK insurance regulatory laws impose no statutory restrictions on an insurer’s ability to declare a dividend, the PRA’s and FCA’s capital requirements in practice act as a restriction on the payment of dividends, where a firm has a lower level of regulatory capital than its regulatory capital requirement as is the case for Ambac UK. Further, the FSA amended Ambac UK’s license in 2010 such that the PRA must specifically approve (“non-objection”) any transfer of value and/or assets from Ambac UK to Ambac Assurance or any other Ambac group company, other than in respect of certain disclosed contracts between the two parties (such as in respect of a management services agreement between Ambac Assurance and Ambac UK).
Pursuant to the Settlement Agreement, Ambac Assurance may not make any “Restricted Payment” (which includes dividends from
Ambac Assurance to Ambac) in excess of $5 million in the aggregate per annum, other than Restricted Payments from Ambac Assurance to Ambac in an amount up to $7.5 million per annum solely to pay operating expenses of Ambac. Concurrent with making any such Restricted Payment, a pro rata amount of Ambac Assurance's surplus notes (other than junior surplus notes) would also need to be redeemed at par.
The Stipulation and Order requires OCI approval for the payment of any dividend or distribution on the common stock of Ambac Assurance.
Under the terms of Ambac Assurance’s Auction Market Preferred Shares (“AMPS”), dividends may not be paid on the common stock of Ambac Assurance unless all accrued and unpaid dividends on the AMPS for the then current dividend period have been paid, provided, that dividends on the common stock may be made at all times for the purpose of, and only in such amounts as are necessary for, enabling Ambac (i) to service its indebtedness for borrowed money as such payments become due or (ii) to pay its operating expenses. If dividends are paid on the common stock as provided in the prior sentence, dividends on the AMPS become cumulative until the date that all accumulated and unpaid dividends have been paid on the AMPS.
INVESTMENTS AND INVESTMENT POLICY
As of December 31, 2017, the consolidated non-VIE investments of Ambac had an aggregate fair value of approximately $5.74 billion. Investments are managed both internally by officers of Ambac, who are experienced investment managers and by external investment managers. All investments are made in accordance with the general objectives, policies, and guidelines for investments reviewed or overseen by Ambac Assurance and Ambac UK’s respective Boards of Directors. These policies and guidelines include liquidity, credit quality, diversification and duration objectives and are periodically reviewed and revised as appropriate. Additionally, senior credit personnel monitor the portfolio on a continuous basis. Credit monitoring of the investment portfolio includes procedures on residential mortgage-backed securities consistent with those utilized to assess the risk of our insured RMBS exposures.
As of December 31, 2017, the Ambac Assurance and Everspan non-VIE investment portfolio had an aggregate fair value of approximately $4.86 billion. Ambac Assurance’s and Everspan’s investment objectives are to achieve the highest risk-adjusted after-tax return on a diversified portfolio consistent with Ambac Assurance’s and Everspan’s risk tolerance while employing active asset/liability management practices to satisfy all operating and strategic liquidity needs. In addition to internal investment policies and guidelines, Ambac Assurance’s investment portfolio is subject to limits on the types and quality of investments imposed by applicable insurance laws and regulations, which may be waived by the applicable regulatory authority in certain instances. The Board of Directors of Ambac Assurance approves any changes to Ambac Assurance's investment policy. Ambac Assurance purchases Ambac Assurance insured securities given their relative risk/reward characteristics. As described in Note 1. Background and Business Description to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K, changes to Ambac Assurance’s investment policies are subject to approval by OCI pursuant to covenants made by Ambac Assurance in the Settlement
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Agreement and Stipulation and Order. Such requirements could adversely impact the performance of the investment portfolio.
As of December 31, 2017, the non-VIE Ambac UK investment portfolio had an aggregate fair value of approximately $0.70 billion. Ambac UK’s investment policy is designed with the primary objective of ensuring that Ambac UK is able to meet its financial obligations as they fall due, in particular with respect to policy holder claims. Ambac UK purchases Ambac UK insured securities given their relative risk/reward characteristics. Ambac UK’s investment portfolio is subject to internal investment guidelines and may be subject to limits on types and quality of investments imposed by its regulator. The Board of Directors of Ambac UK approves any changes or exceptions to Ambac UK’s investment policy.
As of December 31, 2017, the non-VIE Ambac (parent company only) investment portfolio had an aggregate fair value of approximately $0.16 billion. The primary investment objective is to preserve capital for strategic uses while maximizing income. The investment portfolio is subject to internal investment guidelines. Such guidelines set forth minimum credit rating requirements and credit risk concentration limits. Additionally, as of December 31, 2017, this portfolio has $0.20 billion in surplus notes that were issued by Ambac Assurance or the Segregated Account which are eliminated in consolidation.
The following table provide certain information concerning the consolidated investments of Ambac:
($ in millions)
U.S. government obligations
U.S. agency obligations
Residential mortgage-backed securities
Total long-term investments
Other investments (3)
Yields are stated on a pre-tax basis, based on average amortized cost for both long and short term investments.
Includes investments guaranteed by Ambac Assurance and Ambac UK. Refer to Note 10. Investments of the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K for further discussion of Ambac insured securities held in the investment portfolio.
Other investments include equity interests in pooled investment funds which are classified as trading securities and Ambac's interests in an unconsolidated trust created in connection with its sale of Segregated Account junior surplus notes on August 28, 2014.
Ambac's exposure to RMBS in its investment portfolios is further discussed in Part II, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Balance Sheet” section below for a discussion of the fair value of mortgage and asset-backed securities by classification.
As of December 31, 2017, Ambac had 113 employees in the United States and 11 employees in the UK. Ambac considers its employee relations to be satisfactory.
Item 1A. Risk Factors
References in the risk factors to “Ambac” are to Ambac Financial Group, Inc. References to “we,” “our,” “us” and “Company” are to Ambac and its subsidiaries, as the context requires. Capitalized terms used but not defined in this section shall have the meanings ascribed thereto in Part I, Item 1 in this Form 10-K or in Note 1. Background and Business Description or Note 14. Income Taxes to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K unless otherwise indicated.
Certain of the risk factors described below refer to Secured Notes and Tier 2 Notes, which were issued in February 2018 in connection with the transactions described in Note 1. Background and Business Description and Note 17. Subsequent Events to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K. Our risk factors are organized in the following sections.
Risks Related to Ambac Common Shares
Risks Related to Insured Portfolio Losses
Risks Related to Indebtedness
Risks Related to Capital, Liquidity and Markets
Risks Related to the Company's Business
Risks Related to International Business
Risks Related to Taxation
Changes in Political or Economic Conditions
Risks Related to Strategic Plan
Risks Related to Ambac Common Shares
Investments in Ambac's common stock are highly speculative and the price per share of Ambac's common stock may be subject to a high degree of volatility, including significant price declines.
Ambac's common stock, which was issued pursuant to its Reorganization Plan, began trading on the NASDAQ Global Market on May 1, 2013. Although Ambac's common stock is listed on NASDAQ, there can be no assurance as to the liquidity of the trading market or the price at which such shares can be sold. The price of the shares may decline substantially in response to a number of events or circumstances, including but not limited to:
adverse developments in our financial condition or results of operations;
changes in the actual or perceived risk within our insured portfolio, particularly with regards to concentrations of credit risk, such as to Puerto Rico;
changes to regulatory status;
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changes in investors’ or analysts’ valuation measures for our stock;
market trends unrelated to our stock;
market and industry perception of our success, or lack thereof, in pursuing our business strategy; and
results and actions of other participants in our industry.
In addition, the price of Ambac's shares may be affected by the additional risks described below, including risks associated with Ambac Assurance’s ability to deliver value to Ambac. Investments in Ambac's common stock should be considered highly speculative and may be subject to a high degree of volatility.
Ambac may not be able to realize value from Ambac Assurance or generate earnings apart from Ambac Assurance.
The value of Ambac's stock is dependent upon the residual value of its main operating subsidiary, Ambac Assurance; the receipt of payments to be made by Ambac Assurance pursuant to the Amended TSA and the intercompany Cost Allocation Agreement; the receipt of payments on the Owner Trust Certificate issued to Ambac by Corolla Trust (the "Owner Trust Certificate"); the receipt of payments on investments made on securities issued or insured by Ambac Assurance; the receipt of dividends from Ambac Assurance; and the receipt of payments on other investments. There can be no assurance that Ambac will be able to realize residual value in Ambac Assurance, which is in run-off. It is unclear whether Ambac Assurance will be able to satisfy all of its obligations to policyholders, holders of its surplus notes (including junior surplus notes) and holders of its preferred stock, even if Ambac Assurance is successful in achieving recoveries and mitigating losses. Our ability to achieve recoveries and mitigate losses is subject to significant risks and uncertainties, including as a result of varying potential perceptions of the value of Ambac Assurance’s guarantees and securities.
Due to the above considerations, as well as applicable legal and contractual restrictions described elsewhere herein, it is highly unlikely that Ambac Assurance will be able to pay Ambac any dividends for the foreseeable future. Furthermore, the payments to be made to Ambac under the Amended TSA and the intercompany Cost Allocation Agreement are subject to contingencies that are difficult to predict, making the amount and timing, if any, of such payments uncertain. Payments to be made under the Amended TSA, in particular, depend on the generation of future taxable income by Ambac Assurance above certain thresholds. Ambac Assurance’s ability to generate taxable income above such thresholds is uncertain. Due to these factors, there can be no assurance as to the amounts that Ambac will receive from Ambac Assurance under the Amended TSA. Moreover, the Cost Allocation Agreement provides that Ambac Assurance's reimbursement of Ambac's operating expenses after 2017 is subject to the approval of OCI and limited to $4.0 million per annum. We can provide no assurance as to whether OCI will approve such reimbursement or any portion thereof.
It is also uncertain whether and to what extent Ambac will realize value from the Owner Trust Certificate. The Owner Trust Certificate is subordinated to $299.2 million of senior secured notes issued by Corolla Trust. Such notes and the Owner Trust Certificate are collateralized by and payable solely from a $350.0
million face amount junior surplus note plus interest thereon. Ambac Assurance became the obligor under the junior surplus notes on February 12, 2018 pursuant to the Second Amended Plan of Rehabilitation. No payment of interest on or principal of a junior surplus note may be made until all existing and future indebtedness of Ambac Assurance, including senior ranking surplus notes, policy claims and claims having statutory priority, have been paid in full. All payments of principal and interest on junior surplus notes are subject to the prior approval of OCI. If OCI does not approve the payment of interest on junior surplus notes, such interest will accrue and compound annually until paid. Payments on the senior secured notes issued by Corolla Trust will only be made when and to the extent that Ambac Assurance makes payments on the junior surplus note held by Corolla Trust. The senior secured notes must be paid in full before any payments will be made on the Owner Trust Certificate. If Corolla Trust has failed to pay all interest and principal outstanding on the senior secured notes within three business days of August 28, 2039, the senior secured noteholders may also take possession of and sell the junior surplus note. If such a sale were to occur, it is uncertain whether and to what extent there would be any value for the Owner Trust Certificate after satisfaction of the senior secured notes.
The value of Ambac's common stock may also depend upon the ability of Ambac to generate earnings apart from Ambac Assurance. As noted below, Ambac is selectively exploring potential business opportunities that, among other things, may permit utilization of Ambac’s net operating loss carry-forwards, but there are no assurances regarding its ability to find or execute such business opportunities or the prospects of any such opportunities.
Future offerings of debt or equity securities that rank senior or pari-passu to Ambac's common stock may adversely affect the market price of its common stock.
If Ambac decides to issue debt or additional equity securities in the future that rank senior or pari-passu to its common stock, it is likely that they will be governed by an indenture or other instrument containing covenants restricting Ambac's operating flexibility. Additionally, any convertible or exchangeable securities issued in the future may have rights, preferences and privileges more favorable than those of common stock and may result in dilution to owners of common stock. Because Ambac's decision to issue debt or equity securities in any future offering will depend on market conditions, it cannot predict or estimate the amount, timing or nature of future offerings. Holders of common stock bear the risk of future offerings reducing the market price of Ambac's common stock and diluting the value of their stock holdings in the Company.
The issuance of new common stock may dilute current shareholder value or have adverse effects on the market price of Ambac's common stock.
If Ambac raises capital through the issuance of additional shares of common stock, whether for select business transactions, general corporate purposes, or in exchange for other securities, the value of current shareholders’ interests may be diluted as Ambac is not required to offer any such shares to existing stockholders on a preemptive basis.
Ambac cannot predict the effect, if any, of future sales of its common stock, or the availability of shares for future sales, on the
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market price of its common stock. Sales of substantial amounts of common stock or the perception that such sales could occur may adversely affect the prevailing market price for its common stock.
The occurrence of certain events could result in the initiation of rehabilitation proceedings against Ambac Assurance, with resulting adverse consequences to holders of our securities.
Increased loss development in the insured portfolio of Ambac Assurance or significant losses or other events resulting from litigation against Ambac Assurance may prompt OCI to determine that it is in the best interests of policyholders to initiate rehabilitation proceedings with respect to Ambac Assurance, either preemptively or in response to any such event.
A group of entities allowed to participate in the confirmation hearings for the Second Amended Plan of Rehabilitation for the Segregated Account has indicated that it would appeal the order approving the Second Amended Plan. We can provide no assurance that an appeal of the approval order will not be successful and result in the approval order being overturned or modified, or necessitate changes to the Second Amended Plan. Ambac, Ambac Assurance and their respective security holders would face substantial uncertainty and risk if the appeal is successful. Among other possibilities, Ambac Assurance may lose control rights in transactions, which would expose the Company to significantly increased risks and potential losses.
Even if the Second Amended Plan of Rehabilitation and/or the related approval order of the Rehabilitation Court is not modified or overturned, there can be no assurance that any level of capital deemed sufficient by OCI to permit the conclusion of the Segregated Account rehabilitation will be sufficient to cover all future losses, whether currently anticipated or unanticipated.
If, as a result of the occurrence of any such event(s), OCI decides to initiate rehabilitation proceedings with respect to Ambac Assurance, adverse consequences may result, including, without limitation and absent enforceable protective injunctive relief, the assertion of damages by counterparties (including mark-to-market claims with respect to insured transactions executed in ISDA format), the acceleration of losses based on early termination triggers and the loss of control rights in insured transactions. Any such consequences may reduce the residual value of Ambac Assurance. Additionally, the rehabilitator would assume control of all of Ambac Assurance’s assets and management of Ambac Assurance. In exercising control, the rehabilitator would act for the benefit of policyholders, and would not take into account the interests of our securityholders. Such actions may result in material adverse consequences for our securityholders.
Risks Related to Insured Portfolio Losses
Loss reserves may not be adequate to cover potential losses; changes in loss reserves may result in further volatility of net income and comprehensive income.
Loss reserves are established when management has observed credit deterioration, in most cases, when the underlying credit is considered adversely classified. Loss reserves established with respect to our non-derivative financial guarantee insurance policies are based upon estimates and judgments by management, including estimates and judgments with respect to the probability of default, the severity of loss upon default, management’s ability to execute policy commutations, and estimated remediation recoveries for,
among other things, breaches by RMBS issuers of representations and warranties. The objective of establishing loss reserve estimates is not to, and our loss reserves do not, reflect the worst possible outcome. While our reserving scenarios reflect a wide range of possible outcomes (on a probability weighted basis) reflecting the significant uncertainty regarding future developments and outcomes, our loss reserves may change materially based on future developments. As a result of inherent uncertainties in the estimates and judgments made to determine loss reserves, there can be no assurance that either the actual losses in our financial guarantee insurance portfolio will not exceed such reserves or that our reserves will not increase or decrease materially over time as circumstances, our assumptions, or our models change.
Additionally, inherent in our estimates of loss severities and remediation recoveries is the assumption that Ambac Assurance will retain control rights in respect of our insured portfolio. However, according to the terms of relevant transaction documents, Ambac Assurance may lose control rights in many insured transactions if, among other things, Ambac Assurance is the subject of delinquency proceedings and/or other regulatory actions which could result from its deteriorated financial position. If Ambac Assurance loses control rights, its ability to mitigate loss severities and realize remediation recoveries will be compromised, and actual ultimate losses in its insured portfolio could exceed current loss reserves. The Second Amended Plan of Rehabilitation of the Segregated Account and related orders of the Rehabilitation Court seek to restrain actions adverse to Ambac Assurance based on a loss of control rights due to the rehabilitation of the Segregated Account or related events or circumstances. If the Second Amended Plan of Rehabilitation and such orders do not successfully preclude such actions, Ambac Assurance could lose its control rights with respect to certain policies.
Some issuers of public finance obligations insured by Ambac Assurance are experiencing fiscal stress that could result in increased losses on those obligations or increased liquidity claims, including losses or claims resulting from payment defaults, Chapter 9 bankruptcy or other restructuring proceedings or loss of market access.
Some issuers of public finance obligations insured by Ambac Assurance have reported or may report budget shortfalls, significantly underfunded pensions or other fiscal stresses that imperil their ability to pay debt service or will require them to significantly raise taxes and/or cut spending in order to satisfy their obligations. Government entities may also take other actions that may impact their own creditworthiness or the creditworthiness of related issuers. Some issuers of obligations insured by Ambac Assurance have declared a payment moratorium, defaulted or filed for bankruptcy or similar debt adjustment proceedings, raising concerns about their ultimate ability to service the debt insured by Ambac Assurance and Ambac Assurance's ability to recover claims paid in the future. If the issuers of the obligations in the public finance portfolio are unable to raise taxes, cut spending, or receive federal or state assistance, or if such issuers default or file for bankruptcy under Chapter 9 or for similar relief under other laws that allow for the adjustment of debts, Ambac Assurance may experience liquidity claims and/or ultimate losses on those obligations, which could adversely affect the Company's business, financial condition and results of operations.
| Ambac Financial Group, Inc. 12 2017 FORM 10-K |
Ambac Assurance insures obligations of Commonwealth of Puerto Rico, including its authorities and public corporations, that are either subject to a Title III bankruptcy protection proceeding under the Puerto Rico Oversight, Management and Stability Act ("PROMESA") or have otherwise suspended debt service payments. Ambac Assurance may be required to make significant amounts of policy payments over the next several years, the recoverability of which is subject to great uncertainty, which may lead to material permanent losses. While we believe our reserves are adequate to cover losses in the Puerto Rico insured portfolio, there can be no assurance that Ambac Assurance may not incur additional losses in the future, particularly given the developing economic, political and legal circumstances in Puerto Rico. Such losses may have a material adverse effect on Ambac Assurance's results of operation and financial condition.
Ambac Assurance has exposure to the Commonwealth of Puerto Rico (the "Commonwealth"), including its authorities and public corporations. Each has its own credit risk profile attributable to discrete revenue sources, direct general obligation pledges and general obligation guarantees. Overall, Ambac Assurance has approximately $2.0 billion of net par exposure to the Commonwealth and these instrumentalities. Components of the overall Puerto Rico net par outstanding include capital appreciation bonds that are reported at the par amount at the time of issuance of the related insurance policy as opposed to the current accreted value of the bond. The outstanding net insured amount including accretion on capital appreciation bonds is approximately $2.7 billion. Total net insured lifetime debt service (net par and interest) to the Commonwealth of Puerto Rico and its instrumentalities was approximately $9.5 billion at December 31, 2017.
As a result of the developments described in these Risk Factors and elsewhere in this 10-K (see Part II, Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations - Financial Guarantees in Force), the Commonwealth of Puerto Rico and certain of its instrumentalities will continue to default on debt service payments, including payments owed on bonds insured by Ambac Assurance. Ambac Assurance may be required to make significant amounts of policy payments over the next several years, the recoverability of which is subject to great uncertainty, which may lead to material permanent losses. Our exposure to Puerto Rico is impacted by the amount of monies available for debt service, which is in turn affected by variability in economic growth, tax revenues, essential services expense as well as federal funding of Commonwealth needs. In addition, our exposure to Puerto Rico is impacted by the significant damage to the Commonwealth that was inflicted by Hurricane Maria, which made landfall on September 20, 2017, as well as Hurricane Irma, which passed just north of the island on September 6, 2017. The longer term recovery of the economy of the Commonwealth and its essential infrastructure will likely be highly dependent on the amount, timing and effectiveness of Federal aid. There is historical precedent for meaningful Federal support following other natural disasters in the United States and its territories and, to date, some Federal aid measures have been approved and have already started to assist in the recovery. However, there can be no assurances as to the sufficiency or ultimate level of the aid and as to the effectiveness of the deployment of the aid in benefiting the long term recovery of economic activity in Puerto Rico.
Substantial uncertainty also exists with respect to the ultimate outcome for creditors in Puerto Rico due to legislation enacted by the Commonwealth and the United States, including PROMESA, as well as actions taken in reliance on such laws, including Title III filings. Ambac Assurance is involved in multiple litigations relating to such actions and other issues and may not be successful in pursuing claims or protecting its interests. Ambac Assurance is also participating in a mediation process with respect to potential debt restructurings. Mediation may not be productive or may not resolve Ambac Assurance's claims in a manner that avoids significant losses.
Given the numerous uncertainties existing with respect to the restructuring process and relevant litigations, no assurance can be given that ultimate debt service discounts will not be severe and cause Ambac to experience losses materially exceeding current reserves. It is possible that certain restructuring process solutions, together with associated legislation, budgetary, and/or public policy proposals could be adopted and could significantly or further impair our exposures. In addition, there are possible final legal determinations, including failing to recognize or properly differentiate legal structures and protections applicable to such exposures, that could result in losses exceeding our current reserves by a material amount and our loss reserves would need to be increased. In particular, in a Title III process, should court-approved plans of adjustment for the Commonwealth, COFINA, Puerto Rico Highways and Transportation Authority ("PRHTA"), or any other issuers of Ambac-insured debt that file for Title III protection contemplate discounts to debt service implied by, or even worse than, the Commonwealth’s Revised Fiscal and Economic Growth Plan ("Revised FEGP"), the Fiscal Plan Compliance Act be upheld, or Ambac receive unfavorable judgments in the litigations to which it is a party, Ambac’s financial condition could be materially adversely affected. It is also possible that economic or demographic outcomes may be as, or worse than, forecast under the Commonwealth’s Revised FEGP or under proposals or plans promulgated by the Commonwealth or its instrumentalities in or in connection with a Title III process or otherwise. Even a negotiated restructuring to which Ambac agrees as part of a Title VI, mediation or other process may involve material losses in excess of current reserves. While our reserving scenarios reflect a wide range of possible outcomes reflecting the significant uncertainty regarding future developments and outcomes, given our exposure to Puerto Rico and the economic, fiscal, legal and political uncertainties associated therewith as well as the uncertainties emanating from the damage caused by hurricanes Maria and Irma, our loss reserves may ultimately prove to be insufficient to cover our losses, potentially by a material amount, and may be subject to material volatility.
Implementation of the H.R. 1 (commonly known as the Tax Cuts and Jobs Act) may negatively impact the economic recovery of Puerto Rico, which could result in higher loss severities or an extended moratorium on debt service owed on Ambac Assurance-insured bonds of Puerto Rico and its instrumentalities.
The Tax Cuts and Jobs Act effectively treats Puerto Rico the same as it does any other foreign tax jurisdiction and otherwise makes it less attractive for U.S. taxpayers to move certain operations abroad by, among other things, imposing U.S. federal income tax on a current basis with respect to certain earnings of controlled foreign corporations. This may diminish the Commonwealth of Puerto Rico’s relative attractiveness as a location for foreign
| Ambac Financial Group, Inc. 13 2017 FORM 10-K |
activity of a U.S. multinational group, including those with manufacturing facilities or other business on the island. The legislation comes at a difficult time as the Commonwealth of Puerto Rico recovers from hurricanes Maria and Irma and a multi-year financial crisis. Consequently, the Tax Cuts and Jobs Act could have an adverse impact on the ongoing recovery of the Commonwealth of Puerto Rico by impeding much-needed economic growth, job growth, and revenue generation, which could potentially result in higher loss severities and/or an extended debt service moratorium for Puerto Rico creditors, including the Company.
Implementation of the Tax Cuts and Jobs Act could have a negative impact on issuers of Ambac Assurance-insured municipal bonds.
Under the Tax Cuts and Jobs Act individuals who itemize their deductions on their Federal income tax returns will be limited to $10,000 of deductions for state and local taxes paid in a given year. In states with high income tax rates, such as New York, Connecticut, New Jersey, Maryland, and California, there is a risk that municipal bond issuers could be impacted by lower tax revenues if there is significant out migration by residents to states or municipalities with lower tax rates. Lower tax revenues in these jurisdictions could lead to reduced financial flexibility, lower overall economic activity and increased credit risk and thereby potentially increasing risk to Ambac Assurance with respect to affected issuers with bonds insured by Ambac Assurance.
In addition, the Tax Cuts and Jobs Act reduces the maximum corporate federal income tax rate to 21% from 35%, which could reduce the demand for municipal bond investments by corporations, such as life insurance companies, banks, and credit unions, which currently hold approximately 30% of all outstanding municipal bonds. The impact of reduced demand could result in higher borrowing costs for municipalities and/or reduced refinancing flexibility for issuers of municipal bonds, thereby potentially increasing risk to Ambac Assurance with respect to issuers with municipal bonds insured by Ambac Assurance.
We are subject to credit risk and other risks in our insured portfolio, including related to RMBS and securities backed by student loans. We are also subject to risks associated with adverse selection as our insured portfolio runs off. Measures taken to reduce such risks may have an adverse effect on the Company's operating results or financial position.
Performance of our insured transactions, including (but not limited to) RMBS transactions and those involving securities backed by student loans, can be adversely affected by general economic conditions, such as recession, rising unemployment rates, underemployment, home prices that decline or do not increase in the patterns assumed in our models, increasing foreclosure rates and unavailability of consumer credit, mortgage product attributes, such as interest rate adjustments and balloon payment obligations, borrower and/or originator fraud, mortgage and student loan servicer performance or underperformance and financial difficulty, such as risks related to whether the servicer may be required to delay the remittance of any cash collections held by it or received by it after the time it becomes subject to bankruptcy or insolvency proceedings.
While further deterioration in the performance of consumer assets, including mortgage-related assets and student loans, may occur,
the timing, extent and duration of any future deterioration of the credit markets is unknown, as is the impact on potential claim payments and ultimate losses on the securities within our portfolio. In addition, there can be no assurance that any governmental or private sector initiatives designed to address such credit deterioration in the markets will be successful or inure to the benefit of the transactions we insure. For example, any initiative which permits the discharge of student loan debt in bankruptcy may adversely affect our portfolio. Similarly, servicer settlements with governmental authorities regarding foreclosure or servicing irregularities are generally designed to protect borrowers and may increase losses on securities we insure. In particular, the student loan industry and, specifically, trusts with securities insured by Ambac Assurance have been subject to heightened Consumer Finance Protection Bureau (CFPB) scrutiny and enforcement action over servicing and collections practices and potential chain of title issues and, consequently, any settlements, orders, consents or penalties resulting from CFPB actions, or any failure on the part of servicers or other parties asserting claims against delinquent borrowers to establish title to the loans, could lead to increased losses on securities we insure.
In addition, there can be no assurance that Ambac Assurance would be successful, or that it would not be delayed, in enforcing the subordination provisions, credit enhancements or other contractual provisions of the RMBS that Ambac Assurance insures.
As the runoff of the insured portfolio continues, the proportion of exposures we rate as below investment grade relative to the aggregate insured portfolio is likely to continue to increase, leaving the portfolio increasingly concentrated in higher risk exposures. This risk may result in greater volatility or have adverse effects on the Company's results from operations and on our financial condition.
One of our primary goals is to create shareholder value through transaction terminations, policy commutations, settlements and restructurings that we believe will improve our risk profile. As we take such actions to reduce known and potential risks, such actions may negatively impact our operating results or financial position in one or more reporting periods.
Our credit risk management policies and practices may not adequately identify significant risks.
As described in Part I, Item 1, “Risk Management” in this Form 10-K, we have established risk management policies and practices which seek to mitigate our exposure to credit risk in our insured portfolio. Ongoing surveillance of credit risks in our insured portfolio is an important component of our risk management process. These policies and practices in the past have not insulated us from risks that were unforeseen and which had unanticipated loss severity, and such policies and practices may not do so in the future. There can be no assurance that these policies and practices will be adequate to avoid future losses. If we are not able to identify significant risks, we may not be able to timely remediate such risks, thereby increasing the amount of losses to which we are exposed. An inability to identify significant risks could also result in the failure to establish loss reserves that are sufficient in relation to such risks.
We use analytical models to assist our projection of performance of our insured obligations and our investment portfolio but actual
| Ambac Financial Group, Inc. 14 2017 FORM 10-K |
results could differ materially from the model outputs and related analyses.
We rely on internally and externally developed complex financial models, including default models related to RMBS and waterfall modeling provided by a nationally recognized vendor for RMBS and student loan exposures, to project performance of our insured obligations and similar securities in our investment portfolio. These models assume various conditions, probability scenarios, facts and circumstances, and there can be no assurance that such models accurately predict or measure the quantum of losses, loss reserves and timing of losses. Differences in the models that we employ, and/or uncertainties and/or flaws in these financial models and/or faulty assumptions inherent in these financial models and those determined by management, could lead to material changes in projected outcomes, and could include increased losses, loss reserves and/or other than temporary investment impairments. Moreover, modeled estimates of transaction performance depend in part on the interpretation of contracts and other bases of our legal rights. Such interpretations may prove to be incorrect or different interpretations may be employed by bond trustees and other transaction participants and, ultimately courts, which could lead to increased losses, loss reserves and/or investment impairments.
Potential outcome of litigation relating to certain military housing credit exposures could adversely affect Ambac.
Ambac Assurance is a party to a number of litigations relating to military housing securitization credits, where opposing parties contend that, among other things, Ambac Assurance has lost its control rights due to the existence of an “Ambac Default” caused by, among other things, the recently concluded Segregated Account rehabilitation. If Ambac Assurance is found to have lost control rights in these transactions, our ability to mitigate losses could be significantly compromised, and actual ultimate losses in these military housing transactions could exceed our current loss reserves. Moreover, an adverse outcome relating to the assertion of an “Ambac Default” could prompt other counterparties to make similar assertions, which would increase the risk of losing control rights in other transactions.
Risks Related to Indebtedness
The Secured Notes and Tier 2 Notes are secured primarily by potential recoveries on Ambac Assurance’s RMBS litigations and Ambac Assurance’s ability to obtain, and the timing of, any recovery on the RMBS litigations is subject to significant uncertainty.
The Secured Notes and Tier 2 Notes are primarily secured by Ambac Assurance’s potential recoveries in respect of RMBS litigations. The RMBS litigations arise from Ambac Assurance’s claims of fraud and/or contractual breaches of representations and warranties with respect to certain residential mortgage-backed securities (“RMBS”) transactions insured by Ambac Assurance. These claims are based on, among other things, representations with respect to the characteristics of the securitized loans, the absence of borrower fraud in the underlying loan pools or other misconduct in the origination process, the compliance of loans with the prevailing underwriting policies, and compliance of the RMBS transaction counterparties with policies and procedures related to loan origination and securitization. In such cases, where contract claims are being pursued, the sponsor of the transaction is contractually obligated to repurchase, cure or substitute collateral
for any loan that breaches the representations and warranties. However, generally the sponsors have not honored those obligations and have vigorously defended claims brought against them.
The outcome of any litigation, including the RMBS litigations, is inherently unpredictable, including because of risks intrinsic in the adversarial nature of litigation. Subsequent court motions, appeals and rulings, some of which could relate to the transactions effectuated in connection with the conclusion of the Segregated Account rehabilitation, and the issuance of the Secured Notes or Tier 2 Notes, could delay or otherwise impact any recovery by Ambac Assurance. Moreover, rulings that may be adverse to Ambac Assurance (in any given RMBS litigation, as well as in related matters) could affect Ambac Assurance’s ability to pursue its claims or alter settlement dynamics with RMBS litigation counterparties. There can be no assurance that Ambac Assurance will be successful in prosecuting its claims in the RMBS litigations.
Any litigation award or settlement amount is subject to counterparty credit risk, successor liability and other similar risks of recovery, including that the sponsor is unable to honor its contractual obligations or pay a judgment that Ambac Assurance may obtain in litigation. Some sponsors against which Ambac Assurance has claims have been acquired since the securitized loans were originated and their successors may decline to honor the sponsor’s obligations. Ambac Assurance may not be successful in enforcing its claims against any successor entity. There can be no assurance that Ambac Assurance will not have difficulties recovering any damages it may be owed or that it will recover all amounts to which it believes it is entitled or that any actual recoveries will not differ materially from the estimated representation and warranty recoveries the Company has accounted for in its financial statements.
In addition, while a policy issued by Ambac Assurance guarantees all principal and interest payments (including mandatory prepayments) in respect of the Secured Notes as and when such payments become due and owing, such policy may not provide adequate assurance that payments of principal and interest in respect of the Secured Notes will be available in the event that Ambac Assurance’s financial condition, including its capital and liquidity, is materially adversely affected, including as a result of the failure to recover expected damages and, as a result, Ambac Assurance is unable to satisfy its policy obligations. In the event that Ambac Assurance is unable to satisfy its obligations under the Secured Notes policy, holders of the Secured Notes will have the right to foreclose on the securities constituting collateral for the Secured Notes and to sue Ambac Assurance for failure to make payments under the Secured Notes policy; however, there can be no assurance that the sale of the securities collateral will produce proceeds in an amount sufficient to pay any or all amounts due on the Secured Notes or that holders will be successful in any litigation seeking payments pursuant to the Secured Notes policy. Furthermore, holders of Secured Notes will not obtain any control, consultation or direction rights in respect of the RMBS litigations nor will holders be able to sell the Ambac Note or the right to receive proceeds in respect of the RMBS litigations without the prior consent of Ambac Assurance.
Holders of Secured Notes and Tier 2 Notes will have no authority to make decisions in respect of the RMBS litigations, will need to rely on Ambac Assurance to pursue the RMBS litigations and
| Ambac Financial Group, Inc. 15 2017 FORM 10-K |
may only receive limited information concerning the RMBS litigations.
All decisions concerning the conduct of the RMBS litigations, including as to strategy, settlement, pursuit and abandonment, will be made by Ambac Assurance, in consultation with its legal counsel. Holders of the Secured Notes and Tier 2 Notes will have no control over any decisions related to the RMBS litigations and will need to rely on Ambac Assurance to prosecute the underlying claims. If holders do not agree with decisions by Ambac Assurance with respect to the RMBS litigations, there is no recourse or ability to object to such decision. Additionally, Ambac Assurance’s ability to disclose potentially material details of the RMBS litigations on a regular basis may be limited by litigation strategy and the inherent nature and rules of judicial proceedings, including, among other things, proceedings and filings that are sealed by the court, matters involving attorney-client privilege and proceedings that are conducted on a confidential basis by agreement of the parties. The RMBS litigations could also be adversely affected if Ambac Assurance does not have sufficient resources to actively prosecute its claims or becomes subject to rehabilitation, liquidation, conservation or dissolution, or otherwise impaired by actions of OCI.
While Ambac Assurance may pursue negotiated settlements of the RMBS litigations, the settlement discussions may not materialize, may ultimately fail, may cause delays or may result in settlements for less than the amount needed to pay the Secured Notes and Tier 2 Notes.
Ambac Assurance may elect to engage in settlement negotiations with the defendants of the RMBS litigations and may decide to settle any or all of the RMBS litigations. The aggregate amount of settlements may be for an amount less than the amount necessary to pay the Secured Notes or less than the amount necessary to pay the Tier 2 Notes, which could have a material adverse effect on its financial condition or results of operations and make it more difficult for Ambac Assurance to repay the Ambac Note (and therefore make it more difficult for the issuer of the Secured Notes to repay the Secured Notes) and/or the Tier 2 Notes, on a timely basis or at all. Additionally, while Ambac Assurance may pursue settlement negotiations, there can be no assurance that any settlement negotiations will materialize or that any settlement agreement can be reached on terms acceptable to Ambac Assurance, or at all. If settlement discussions prior to trial fail with respect to a particular case, Ambac Assurance could incur greater expenses preparing for, and prosecuting, a trial in such case, and Ambac Assurance’s recovery would be subject to the additional risks inherent in any trial, which could adversely impact the value of the Secured Notes and Tier 2 Notes.
Ambac Assurance may receive non-cash proceeds in respect of the RMBS litigations and may need to liquidate such proceeds for less than fair market value in order to make cash payments on the Ambac Note and/or the Tier 2 Notes.
In connection with a settlement agreement or judgment, Ambac Assurance may receive non-cash proceeds or indirect proceeds, which are cash or non-cash proceeds received by others for the benefit of Ambac Assurance. Ambac Assurance, however, will be required to make payments on the Ambac Note, for the benefit of the holders of Secured Notes, and on the Tier 2 Notes, in cash. In the event that Ambac Assurance receives non-cash proceeds, Ambac Assurance may need to liquidate the non-cash proceeds if
it does not have sufficient cash available to make a payment on the Ambac Note or the Tier 2 Notes on the applicable payment date. Market and economic conditions, governmental actions, the form of non-cash proceeds and other factors may cause substantial delays in the ability to liquidate any non-cash proceeds received. Ambac Assurance may not be able to liquidate any non-cash proceeds received for fair value or at all. If Ambac Assurance is unable to liquidate non-cash proceeds at their fair value, Ambac Assurance will still be required to make payments on the Ambac Note and Tier 2 Notes and any payment made that is greater than the amount received could have a material adverse effect on Ambac Assurance’s financial condition, including its capital and liquidity. If indirect proceeds are received, Ambac Assurance will also be required to make payments on the Ambac Note, for the benefit of the holders of Secured Notes, and on the Tier 2 Notes, in cash to the extent of the fair value to Ambac Assurance of the indirect proceeds. Any payments of cash on the Ambac Note and/or the Tier 2 Notes as the result of receiving indirect proceeds may have a material adverse effect on Ambac Assurance’s financial condition, including its capital and liquidity.
There may not be sufficient collateral to pay any or all of the Secured Notes or Tier 2 Notes.
In addition to Ambac Assurance’s right to representation and warranty recoveries in respect of the RMBS litigations, which is inherently uncertain, the Ambac Note is also secured by securities having an estimated fair market value of approximately $350 million. However, no appraisal of the value of the securities has been made and there can be no assurances that the fair market value of these securities will not decrease, including significantly. The value of the collateral in the event of liquidation will depend on market and economic conditions, the availability of buyers and other factors. Consequently, liquidating the securities collateral securing the Ambac Note may not produce proceeds in an amount sufficient to pay any or all amounts due on the Secured Notes.
The estimated fair market value of the securities collateral securing the Ambac Note is subject to fluctuations based on factors that include, among others, the financial condition of participants in the financial guaranty insurance industry, the market for and availability of financial guaranty insurance, the ability to sell the collateral in an orderly sale, general economic conditions, the availability of buyers and other factors. The amount to be received upon a sale of the securities collateral would be dependent on numerous factors, including, but not limited to, the actual fair market value of the collateral at such time and the timing and the manner of the sale, and the amount Ambac Assurance receives may not equal or exceed the expected fair market value. Accordingly, there can be no assurance that the collateral can be sold in a short period of time or at all or at acceptable prices to Ambac Assurance.
In the event of rehabilitation, liquidation, conservation, dissolution or other insolvency proceeding, Ambac Assurance cannot assure holders that the proceeds from any sale or liquidation of the securities collateral will be sufficient to pay any or all of Ambac Assurance’s obligations under the Ambac Note.
In addition, in the event of any such proceeding, it is possible that the rehabilitator, trustee, or competing creditors will assert that the value of the collateral with respect to the Ambac Note or the Tier 2 Notes, including Ambac Assurance’s rights to recoveries in respect of the RMBS litigations, is less than the then-current
| Ambac Financial Group, Inc. 16 2017 FORM 10-K |
principal amount outstanding under the Ambac Note and the Secured Notes and/or the Tier 2 Notes on the date of the rehabilitation filing. Upon a finding by the court overseeing an Ambac Assurance rehabilitation that the Ambac Note and the Secured Notes and/or the Tier 2 Notes are under-collateralized, the claims in the rehabilitation proceeding with respect to the Ambac Note, the Secured Notes or the Tier 2 Notes may be bifurcated between a secured claim up to the value of the collateral and an unsecured claim for any deficiency. As a result, the claim of the holders of the Secured Notes or the Tier 2 Notes could be unsecured in whole or in part. The ability of the holders of the Secured Notes or Tier 2 Notes to realize upon any of the collateral securing the Ambac Note and the Secured Notes or Tier 2 Notes, as the case may be, may also be subject to bankruptcy and insolvency law limitations or similar limitations applicable in insurance company rehabilitation or liquidation proceedings.
Rights of holders of the Secured Notes in the RMBS litigations and securities collateral and rights of holders of the Tier 2 Notes in the RMBS litigations may be adversely affected by the failure to perfect security interests in such collateral, and insolvency considerations with respect to Ambac Assurance may have an adverse effect on the ability of holders of the Secured Notes and Tier 2 Notes to receive payments on the Secured Notes or Tier 2 Notes, respectively.
Applicable law provides that a security interest in certain tangible and intangible assets can only be properly perfected and its priority retained through certain actions undertaken by the secured party. There can be no assurance that the collateral agent in respect of the Secured Notes or Tier 2 Notes will have taken or will take all actions necessary to create properly perfected security interests in the proceeds from the RMBS litigations, which may result in the loss of the priority of the security interest in favor of the holders of the Secured Notes or the Tier 2 Notes, respectively, to which they would otherwise have been entitled. In particular, in the event of a rehabilitation, liquidation, conservation, dissolution or other insolvency proceeding with respect to Ambac Assurance, if the proceeds from the RMBS litigations received by Ambac Assurance are determined not to be under the control of the Secured Notes Issuer, a receiver or a creditor of Ambac Assurance may take the position that the Secured Notes Issuer’s security interest in such proceeds or a portion thereof is not perfected and therefore that such proceeds do not secure the Ambac Note. With respect to the Tier 2 Notes, in the event of a rehabilitation, liquidation, conservation, dissolution or other insolvency proceeding with respect to Ambac Assurance, if the proceeds from the RMBS litigations received by Ambac Assurance are determined not to be under the control of the collateral agent for the Tier 2 Notes, a receiver or a creditor of Ambac Assurance may take the position that such collateral agent’s security interest in such proceeds or a portion thereof is not perfected and therefore that such proceeds do not secure the Tier 2 Notes. Moreover, if the proceeds from the RMBS litigations are received after the initiation of a rehabilitation, liquidation, conservation, dissolution or other insolvency proceeding with respect to Ambac Assurance, a receiver or a creditor of Ambac Assurance may take the position that such proceeds do not secure the Ambac Note or the Tier 2 Notes. If a court were to accept either of these positions, payments under the Ambac Note or Tier 2 Notes, as applicable, may be adversely affected and the Secured Notes or Tier 2 Notes, as the case may be, may become worthless. In addition, a rehabilitation, liquidation, conservation, dissolution or other insolvency
proceeding with respect to Ambac Assurance or the Secured Notes Issuer, as applicable, could lead to delays in payments due on the Secured Notes or Tier 2 Notes.
Fraudulent transfer laws may permit a court to void the Ambac Note, and if that occurs, holders may not receive any payments on the Secured Notes.
Fraudulent transfer and conveyance statutes may apply to the issuance of the Ambac Note. Under state fraudulent transfer or conveyance laws, which may vary from state to state, the Ambac Note could be voided as a fraudulent transfer or conveyance if Ambac Assurance (a) issued the Ambac Note with the intent to hinder, delay or defraud creditors or (b) received less than reasonably equivalent value or fair consideration in return for issuing the Ambac Note and, in the case of (b) only, one of the following is also true at the time thereof:
Ambac Assurance was insolvent or rendered insolvent by reason of the issuance of the Ambac Note;
the issuance of the Ambac Note left Ambac Assurance with an unreasonably small amount of capital or assets to carry on its business; or
Ambac Assurance intended to, or believed that it would, incur debts beyond its ability to pay as they mature.
In addition, under Wisconsin insurance law, if the Ambac Note were issued within one year prior to the filing of a successful petition for rehabilitation or liquidation with respect to Ambac Assurance, the Ambac Note could be voided as a fraudulent transfer if Ambac Assurance issued the Ambac Note with the intent to hinder, delay or defraud creditors or received less than fair consideration in return for issuing the Ambac Note.
As a general matter, value is given for a transfer or an obligation if, in exchange for the transfer or obligation, property is transferred or a valid antecedent debt is satisfied.
Ambac Assurance cannot be certain as to the standards a court would use to determine whether or not Ambac Assurance was insolvent at the relevant time or, regardless of the standard that a court uses, whether the Secured Notes would be subordinated to Ambac Assurance’s other debt or policyholder claims. In general, however, a court would deem an entity insolvent if:
the sum of its debts, including contingent and unliquidated liabilities, was greater than the fair saleable value of all of its assets;
the present fair saleable value of its assets was less than the amount that would be required to pay its probable liability on its existing debts, including contingent liabilities, as they become absolute and mature; or
it could not pay its debts as they became due.
If a court were to find that the issuance of the Ambac Note was a fraudulent transfer or conveyance, the court could void the payment obligations under the Ambac Note or could subordinate the Ambac Note to presently existing and future indebtedness or policy obligations of Ambac Assurance, and, as a result, holders may not receive any payments on the Secured Notes.
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We have substantial indebtedness, which could adversely affect our financial condition, operational flexibility and our ability to obtain financing in the future.
We have a substantial amount of indebtedness. Our substantial level of indebtedness and other financial obligations as well as the performance of our insured portfolio, which is driven to an extent by events outside our control, increase the possibility that we may be unable to generate cash sufficient to pay, when due, the principal of, interest on, or other amounts due, in respect of our indebtedness. Our cash flow generation will depend on receipt of premiums, investment returns, and potential litigation recoveries, offset by policyholder claims, commutation payments and operating expenses, which will be subject to prevailing economic conditions and to financial, business and other factors, many of which are beyond its control and many of which are event-driven. Our substantial debt could also have other significant consequences. For example, it could:
increase our vulnerability to general adverse economic, competitive and industry conditions;
limit our ability to obtain additional financing in the future for working capital, capital expenditures, payment of policyholder claims, debt service requirements, acquisitions, general corporate purposes or other purposes on satisfactory terms or at all;
require us to dedicate a substantial portion of our cash flow from operations to the payment of our indebtedness, thereby reducing the funds available to us for operations and to fund the execution of our key strategies;
limit or restrict us from making strategic acquisitions or cause us to make non-strategic divestitures;
limit our ability or increase the costs to refinance indebtedness or repay such indebtedness due to ongoing interest accretion;
limit our ability to attract and retain key employees; and
limit our ability to enter into hedging transactions by reducing the number of counterparties with whom we can enter into such transactions, as well as the volume of those transactions.
Despite current indebtedness levels, we and our subsidiaries may incur additional debt. While restrictive covenants in certain of our contracts currently provide limits on the amount of additional indebtedness Ambac Assurance may incur, we may obtain a waiver of those restrictions and incur additional indebtedness in the future. In addition, if Ambac incurred indebtedness, its ability to make scheduled payments on, or refinance, any such indebtedness may depend on the ability of our subsidiaries to make distributions or pay dividends, which in turn will depend on their future operating performance and contractual, legal and regulatory restrictions on the payment of distributions or dividends to which they may be subject. There can be no assurance that any such dividends or distributions would be made. This could further exacerbate the risks associated with our substantial leverage.
If we cannot pay policyholder claims or service debt, the Company will have to take actions such as selling assets, restructuring or refinancing debt or seeking additional capital. Any of these remedies may not, if necessary, be effected on commercially
reasonable terms, or at all. Because of these and other factors beyond our control, we may be unable to pay the principal, interest or other amounts on our debt securities.
Ambac Assurance has ongoing obligations related to surplus notes.
Subject to approval by OCI, Ambac Assurance is required to make interest and principal (to the extent due) payments in cash on surplus notes on an annual basis. Ambac Assurance will be required to continue to make such payments, as and when approved by OCI, until all of the surplus notes mature, are repaid in full or are otherwise repurchased or retired. Ambac Assurance is also obligated to make payments on junior surplus notes, subject to OCI approval, after the senior surplus notes have been paid in full. Ambac Assurance may not have the ability to borrow, raise or otherwise have access to the funds necessary to pay such amounts when due.
Surplus notes that were not exchanged and cancelled in the Exchange Offers may be acquired, redeemed or repaid on terms that may be viewed as more, or less, favorable than the terms of the consideration offered in the Exchange Offers.
The Company may acquire, redeem or repay surplus notes that are not exchanged and cancelled in the Exchange Offers through open market purchases, privately negotiated transactions, other tender or exchange offers, redemptions, repayment at maturity or such other means as the Company deems appropriate, subject to the restrictions in the Settlement Agreement, Stipulation and Order and regulatory restrictions. Any such transactions will occur upon the terms and at the prices as the Company may determine in its sole discretion, which may be more or less favorable than the terms of the Exchange Offers, and could be for cash or other consideration. The Company may choose to pursue any or none of these alternatives, or combinations thereof, in the future.
The surplus notes that remain outstanding following the consummation of the Exchange Offers are subordinated in right of payment to other claims, which could impair the right of the holders of such notes to receive interest and principal in the event of our insolvency or a similar occurrence.
The surplus notes are unsecured obligations of Ambac Assurance and are expressly subordinated in right of payment to all of Ambac Assurance’s existing and future indebtedness (other than junior surplus notes) and policy claims. The surplus notes are subject to provisions of Wisconsin insurance law, which establishes the priority of distribution of claims from the estate of an insolvent insurance company. In the event that Ambac Assurance becomes subject to rehabilitation, liquidation, conservation or dissolution, holders of Ambac Assurance’s senior indebtedness and policy claims would be afforded a higher priority of distribution than holders of the surplus notes, and accordingly would have the right to be paid in full before holders of the surplus notes would be paid. Due to the nature of Ambac Assurance’s business, the amount of such higher priority claims in any rehabilitation, liquidation, conservation or dissolution is likely to be many times greater than any free and divisible surplus and it is likely that the holders of surplus notes would not recover any payment in such circumstances. In addition, claims of holders of the surplus notes will be subordinated to certain liabilities of the Company’s subsidiaries that are guaranteed by Ambac Assurance.
| Ambac Financial Group, Inc. 18 2017 FORM 10-K |
Ambac Assurance has not made regular interest or principal payments on surplus notes and may be unable to repay surplus notes in full at maturity or ever.
On November 20, 2014, Ambac Assurance, with the approval of OCI, redeemed surplus notes (other than junior surplus notes) in an amount equal to 26.67% of the principal amount of the surplus notes, plus accrued interest thereon, outstanding as of July 20, 2014, or approximately $396 million owned by third parties. However, except for a one-time payment of approximately six months of interest on the surplus notes (other than junior surplus notes) outstanding immediately after the Exchange Offers, no other interest or principal payments on the surplus notes have been approved or made to date, and Ambac Assurance may not receive approval from OCI to make payments as and when scheduled. As a result, holders of surplus notes may not be paid in full at maturity or ever. If OCI does not begin to approve regular payments on the surplus notes (other than junior surplus notes) within the next several years, the accretion of surplus notes may exceed our ability to ever repay in full the surplus notes. If Ambac Assurance becomes subject to a rehabilitation or liquidation under the Wisconsin insurance law, prior to the repayment of surplus notes, holders of surplus notes may not receive any recoveries on their investments.
The effects of the amendments to the Settlement Agreement in the recently completed consent solicitation done in connection with the Exchange Offers could materially and adversely affect the credit risk inherent in, and significantly reduce protections afforded in, surplus notes not validly tendered and accepted or received as consideration pursuant to the Exchange Offers.
Holders of surplus notes that were not tendered and accepted or were received as consideration pursuant to the Exchange Offers will be subject to the terms of the Settlement Agreement as modified, notwithstanding the fact that they did not deliver consents in the related consent solicitation. Certain restrictive covenants and other related provisions in the Settlement Agreement, including covenants regarding mergers and consolidations and the incurrence of indebtedness, have been modified or eliminated. As a result, holders of surplus notes no longer are entitled to the benefit of such provisions, which existed for the protection and benefit of holders of the surplus notes issued pursuant to the Settlement Agreement. The Settlement Agreement, as so amended, continues to govern the terms of all surplus notes issued thereunder that remain outstanding after the consummation of the Exchange Offers and Rehabilitation Exit Transactions. Accordingly, we may take certain actions in the future previously prohibited under the Settlement Agreement that could adversely affect the market prices of the surplus notes and otherwise increase the risks related to investments in the surplus notes.
Increases in interest rates will increase the cost of servicing our debt could reduce our profitability and could result in a decrease in the value of the Secured Notes.
The Secured Notes will bear interest at a variable rate. As a result, increases in interest rates will increase the cost of servicing the Secured Notes and could adversely affect our profitability and cash flows. Each one percentage point increase in interest rates would result in an $21.8 million increase in the annual cash interest payments due on the Secured Notes.
Changes in inter-bank lending rate reporting practices or the method pursuant to which LIBOR rates are determined may adversely affect the value of LIBOR linked financial instruments.
Since February 1, 2014, the administration of LIBOR has been undertaken by ICE Benchmark Administration Limited (“IBA”), a subsidiary of Intercontinental Exchange Group. IBA, as the administrator of LIBOR, may make changes in methodology that could change the level of LIBOR, which in turn may adversely affect the value of financial instruments linked to LIBOR, including investment securities, swaps, and the Secured Notes. Since 2014, the IBA published multiple papers and other literature, including a “LIBOR Code of Conduct” relating to the setting of LIBOR. IBA has the power to alter, discontinue or suspend calculation or dissemination of LIBOR.
On July 27, 2017, the U.K. Financial Conduct Authority announced that it will no longer persuade or compel banks to submit rates for the calculation of LIBOR rates after 2021 (the “July 27th Announcement”). The July 27th Announcement indicates that the continuation of LIBOR on the current basis cannot and will not be guaranteed after 2021. Consequently, at this time, it is not possible to predict whether and to what extent banks will continue to provide LIBOR submissions to the administrator of LIBOR or whether any additional reforms to LIBOR may be enacted in the United Kingdom or elsewhere. Similarly, it is not possible to predict what rate or rates may become accepted alternatives to LIBOR of the effect of any such alternatives on the value of LIBOR-linked securities. Any of the above changes or any other consequential changes to LIBOR or any alternative rate or benchmark as a result of any international, national, or other proposals for reform or other initiatives or investigations, or any further uncertainty in relation to the timing and manner of implementation of such changes, could have a material adverse effect on the value investments in our investment portfolio, swaps we use for hedging, and the Secured Notes.
The amount of interest payable on the Secured Notes is set only once per interest period based on the three-month LIBOR rate on the applicable interest determination date, which rate may fluctuate substantially, and affect our ability to make payment on the Secured Notes.
In the past, the level of the three-month LIBOR rate has experienced significant fluctuations. Historical levels, fluctuations and trends of the three-month LIBOR rate are not necessarily indicative of future levels. Any historical upward or downward trend in the three-month LIBOR rate is not an indication that the three-month LIBOR rate is more or less likely to increase or decrease at any time during an interest period for the Secured Notes, and historical levels of the three-month LIBOR rate should not be taken as an indication of its future performance. In addition, although the actual three-month LIBOR rate on an interest payment date or at other times during an interest period may be higher than the three-month LIBOR rate on the applicable interest determination date, the only relevant date for purposes of determining the interest payable on the Secured Notes is the three-month LIBOR rate as of the respective interest determination date. Changes in the three-month LIBOR rates between interest determination dates will not affect the interest payable on the Secured Notes. As a result, changes in the three-month LIBOR rate may not result in a comparable change in the market value of the Secured Notes.
| Ambac Financial Group, Inc. 19 2017 FORM 10-K |
The Secured Notes will bear interest at floating rates that could rise significantly, increasing Ambac Assurance’s interest expense and reducing its cash flow. If Ambac Assurance’s interest expense increases significantly, whether due to changes in LIBOR or increased borrowing costs when its refinances its current indebtedness, Ambac Assurance may not be able to make payments with respect to the Secured Notes or its other indebtedness.
Ambac’s representation and warranty recovery may change over time, causing the value or the perceived value of the collateral securing the Secured Notes and Tier 2 Notes to change and any such changes may be material.
Ambac reevaluates its estimated representation and warranty recoveries on a quarterly basis in connection with the preparation of its financial statements. See “Critical Accounting Policies and Estimates” in Part II, Item 7, Note 2. Basis of Presentation and Significant Accounting Policies and Note 7. Financial Guarantee Insurance Contracts to the Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K for the fiscal year ended December 31, 2017. As a result of any reevaluation, the amount of Ambac’s representation and warranty recovery may be adjusted upward or downward due to, among other things, changes in management's view of the value of such recoveries and/or changes in the loss reserves related to such recoveries, and any adjustment may be material. Changes in representation and warranty recoveries may result in material changes in Ambac’s financial condition, including its capital and liquidity. In addition, any adjustment to representation and warranty recoveries may alter the value or the perceived value of the collateral securing the Secured Notes and Tier 2 Notes before payment on the Secured Notes or Tier 2 Notes is made in full, which may affect the value of, and trading market, if any, for, the Secured Notes or Tier 2 Notes. Management makes no representation that the representation and warranty recoveries will not change, materially or at all, including in the near term. There can be no assurance that the apparent, or actual, value of the collateral securing the Secured Notes and Tier 2 Notes will equal or exceed the principal amount of the Secured Notes and Tier 2 Notes, respectively, at all times prior to maturity.
Risks Related to Capital, Liquidity and Markets
Our inability to realize the expected recoveries included in our financial statements could adversely impact our liquidity, financial condition and results of operations and the value of the Secured Notes and Tier 2 Notes.
As of December 31, 2017, we have estimated representation and warranty subrogation recoveries of $1,806.7 million (net of reinsurance) included in our financial statements. These recoveries are based on contractual claims arising from RMBS transactions that Ambac Assurance has insured, and represent a probability-weighted estimate of amounts we expect to recover under various possible scenarios, and do not represent the best or the worst possible outcomes with respect to any particular transaction or group of transactions. Our ability to recover these amounts and the time of the recoveries, if any, is subject to significant uncertainty, including risks inherent in litigation, collectability of such amounts from counterparties and/or their respective parents and affiliates, timing of receipt of any such recoveries, intervention by OCI, which could impede Ambac Assurance's ability to take the actions required to realize such recoveries, and uncertainties inherent in the assumptions used in estimating such recoveries. The amount
of these subrogation recoveries is significant and if we were unable to recover such amounts, our stockholders’ equity as of December 31, 2017 would decrease from $1,645.3 million to $(161.4) million.
We expect to recover material amounts of claims payments through remediation measures including the litigation described above as well as through cash flows in the securitization structures of transactions that Ambac Assurance insures. Realization of such expected recoveries is subject to various risks and uncertainties, including the rights and defenses of other parties with interests that conflict with Ambac Assurance's interests, the performance of the collateral and assets backing the obligations that Ambac Assurance insures, the performance of servicers involved in securitizations in which Ambac Assurance participates as insurer, and the effect on Ambac Assurance's rights of the Segregated Account rehabilitation. Additionally, our ability to realize recoveries in insured transactions may be impaired if orders of the Rehabilitation Court are not effective.
Adverse developments with respect to such variables may cause our recoveries to fall below expectations, which could have a material adverse effect on our financial condition, including our capital and liquidity.
Ambac’s estimate of RMBS litigation recoveries is subject to significant uncertainty and changes to the estimate could adversely impact its liquidity, financial condition and results of operations.
For Ambac’s current RMBS cases for which it records a representation and warranty recovery in its financial statements, Ambac has been provided access to loan files for all loans in the relevant original pool and Ambac utilizes a “random sample” approach to estimate such recoveries. Ambac does not include estimates of damages attributed solely to fraudulent inducement claims in its estimate of representation and warranty recoveries.
The amount estimated for purposes of Ambac’s representation and warranty recovery and the amount Ambac may ultimately receive is subject to significant uncertainty, including risks inherent in litigation, collectability of such amounts from counterparties and/or their respective parents and affiliates, timing of receipt of any recoveries, intervention by the OCI, which could impede Ambac’s ability to take actions required to realize recoveries, and uncertainties inherent in the assumptions used in estimating any recoveries. In particular, Ambac’s assumptions regarding default rates of the loans and Ambac’s expectations with respect to the RMBS litigations have a significant impact on Ambac’s estimated representation and warranty recoveries. If these assumptions, expectations or estimates prove to be incorrect, or if an investor were to use different assumptions, expectations or estimates to predict recoveries, actual recoveries could differ materially from those estimated. Actual recovery will ultimately depend on future events and there can be no assurance that the assumed default rates or estimated RMBS litigations recoveries will not differ from actual events. Although Ambac believes that its methodology for extrapolating estimated recoveries is appropriate for evaluating the amount of potential recoveries, the methodologies Ambac uses to estimate expected losses in general and for any specific obligation in particular may not be similar to methodologies used by Ambac’s competitors, counterparties or other market participants. The determination of expected recovery is an inherently subjective
| Ambac Financial Group, Inc. 20 2017 FORM 10-K |
process involving numerous estimates, assumptions and judgments by management, using both internal and external data sources with regard to frequency, economic projections and other factors that affect credit performance. As a result, Ambac’s current estimates may not reflect Ambac’s future ultimate recovery and management makes no representation that the actual amount recovered, if any, will not differ materially from those estimated. The failure of Ambac’s actual recovery to meet or exceed its current estimate could result in a material adverse effect on Ambac’s financial condition, including its capital and liquidity.
The surplus notes that remain outstanding and that were received by holders of Deferred Amounts from Ambac pursuant to the Second Amended Plan of Rehabilitation may not be fungible with the other surplus notes that remain outstanding following the consummation of the Exchange Offers.
The surplus notes that were held by Supporting Holders but were not accepted for tender and that remain outstanding following the consummation of the Exchange Offers will accrue original issue discount (“OID”) in a manner that differs from the accrual of OID on the surplus notes received by holders of Deferred Amounts from Ambac pursuant to the Second Amended Plan of Rehabilitation, and, therefore, the surplus notes that were held by Supporting Holders but were not accepted for tender and that remain outstanding following the consummation of the Exchange Offers will not be fungible with the surplus notes received by holders of Deferred Amounts from AFG pursuant to the Second Amended Plan of Rehabilitation for U.S. federal income tax purposes.
We may not be able to commute or reduce insured exposures.
In pursuing the objective of improving its financial position, we are seeking to commute or reduce insured exposures. Transactions of this nature may not be feasible or economically viable. We cannot provide any assurance that any such transaction will be consummated in the future, or if it is, as to the timing, terms or conditions of any such transaction. Even if we consummate one or more such transactions, doing so may ultimately prove to be unsuccessful in creating value for any or all of our stakeholders and may adversely affect our operating results or financial position.
Revenues and cash flow would be adversely impacted by a decline in realization of installment premiums.
Due to the installment nature of a significant percentage of its premium income, Ambac Assurance has an embedded future revenue stream. The amount of installment premiums actually realized by Ambac Assurance could be reduced in the future due to factors such as early termination of insurance contracts, accelerated prepayments of underlying obligations or insufficiency of cash flows (by the premium paying entity). Additionally, the Segregated Account rehabilitation may result in the loss of installment premium income from such insured transactions if orders of the Rehabilitation Court are not effective. Such reductions would result in lower revenues.
The change in composition of the securities in our investment portfolio exposes us to greater risk.
Each of Ambac Assurance and Ambac Assurance UK Limited (“Ambac UK”) maintains a portion of its investment portfolio in lower-rated securities and/or “alternative assets” in order to increase the risk-adjusted return on its portfolio. Investments in lower-rated securities and “alternative assets” could expose Ambac
and/or Ambac UK to greater earnings volatility, increased losses and decreased liquidity in the investment portfolio.
We may have future capital needs and may not be able to obtain third-party financing or raise additional third-party capital on acceptable terms, or at all.
An inability to obtain third-party debt financing or raise additional third-party capital, when required by us or when business conditions warrant, could have a material adverse effect on our business, financial condition and results of operations. The economic conditions affecting our industry, as well as other factors, may constrain our financing abilities. Our ability to secure third-party financing, if available, and to satisfy or refinance our financial obligations under indebtedness outstanding from time to time will depend upon regulatory conditions, our future operating performance, the availability of credit generally, economic conditions and financial, business and other factors, many of which are beyond our control. The market conditions and the macroeconomic conditions that affect our industry could have a material adverse effect on our ability to secure third-party financing on favorable terms, if at all.
If third-party financing is not available when needed, or is available on unfavorable terms, we may be unable to take advantage of business opportunities, respond to competitive pressures or refinance our outstanding indebtedness, any of which could have a material adverse effect on our business, financial condition and results of operations.
Ambac Assurance may in the future report a policyholders’ deficit or become insolvent.
Our expected financial condition after the consummation of the Rehabilitation Exit Transactions is based on various assumptions concerning these transactions, including accounting and tax treatment. There can be no assurance that the assumptions will not differ materially from the ultimate results of such transactions and any differences may be material. In addition, while the Rehabilitation Exit Transactions and related transactions were designed to improve our financial condition, we will continue to be subject to risks and uncertainties that could materially affect our financial position. Therefore, even following consummation of the Rehabilitation Exit Transactions, circumstances may occur that would cause Ambac Assurance to report a policyholders’ deficit or not comply in the future with the statutory minimum policyholders’ surplus or undergo rehabilitation. In addition, Ambac Assurance may become insolvent in the future. OCI has prescribed or permitted additional accounting practices for Ambac Assurance and Everspan which are described in Note 8. Insurance Regulatory Restrictions to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K. If Ambac Assurance and Everspan are unable to utilize the permitted or prescribed practices, we may not comply with the statutory minimum policyholders’ surplus.
The determination of the amount of other-than temporary impairments taken on our investments is highly subjective and could materially impact our results of operations or financial position.
The determination of the amount of impairments on our investments varies by investment type and is based upon our periodic evaluation and assessment of known and inherent risks associated with the respective asset class. Such evaluations and
| Ambac Financial Group, Inc. 21 2017 FORM 10-K |
assessments are revised as conditions change and new information becomes available. Management updates its evaluations regularly and reflects changes in impairments as such evaluations are revised. There can be no assurance that our management has accurately assessed the level of impairments taken in our financial statements. Furthermore, additional impairments may need to be taken in the future. Historical trends may not be indicative of future impairments. In particular, we use externally developed financial models to project impairments with respect to RMBS held in our investment portfolio, including Ambac Assurance guaranteed RMBS. Differences in the models we employ and/or flaws in these models and/or faulty assumptions inherent in these models and those determined by management, could lead to increased impairments with respect to RMBS in our investment portfolio.
Risks Related to the Financial and Credit Markets
Changes in prevailing interest rate levels and market conditions could adversely impact our business results and prospects.
Increases in prevailing interest rate levels can adversely affect the value of our investment portfolio and, therefore, our financial strength. In the event that investments must be sold in order to pay claims, to pay debt obligations, or to meet Financial Services liquidity needs due to contract terminations or collateral posting requirements, such investments would likely be sold at discounted prices. Additionally, increasing interest rates would have an adverse impact on our insured portfolio. For example, increasing interest rates could result in higher claim payments in respect of defaulted obligations that bear interest at floating rates of interest. Higher interest rates can also lead to increased credit stress on consumer asset-backed transactions (as the securitized assets supporting a portion of these exposures are floating rate consumer obligations), slower prepayment speeds and resulting “extension risk” relative to such consumer asset-backed transactions in our insured and investment portfolios, and decreased refinancing activity.
Decreasing interest rates could result in early terminations of financial guarantee insurance policies in respect of which we are paid on an installment basis and do not receive a termination premium, thus reducing premium earned for these transactions. Decreases in prevailing interest rates may also limit growth of or reduce investment income and may adversely impact our interest rate swap portfolio.
Our investment portfolio may also be adversely affected by credit rating downgrades, ABS and RMBS prepayment speeds, foreign exchange movements, spread volatility, and credit losses.
We are subject to credit risk throughout our businesses, including large single risks, risk concentrations, correlated risks and reinsurance counterparty credit risk.
We are exposed to the risk that issuers of debt which we have insured (or with respect to which we have written credit derivatives), issuers of debt which we hold in our investment portfolio, reinsurers and other contract counterparties (including derivative counterparties) may default in their financial obligations, whether as the result of insolvency, lack of liquidity, operational failure, fraud or other reasons. These credit risks could cause increased losses and loss reserves, and/or estimates of credit impairments and mark-to-market losses with respect to credit derivatives in our financial guarantee business; and we could
experience losses and decreases in the value of our investment portfolio and, therefore, our financial strength. Such credit risks may be in the form of large single risk exposures to particular issuers, reinsurers or counterparties; losses caused by catastrophic events (including terrorist acts and natural disasters); losses caused by increases in municipal defaults; or losses in respect of different, but correlated, credit exposures.
Risks Related to the Company's Business
We are subject to the risk of litigation and regulatory inquiries or investigations, and the outcome of proceedings we are or may become involved in could have a material adverse effect on our business, operations, financial position, profitability or cash flows.
Ambac Assurance is defending various lawsuits relating to its financial guarantee business. In addition, the Company from time to time receives various regulatory inquiries and requests for information. Please see Note 16. Commitments and Contingencies to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K for information on these various proceedings.
It is not possible to predict whether additional suits will be filed against Ambac, Ambac Assurance or one or more other subsidiaries or whether additional regulatory inquiries or requests for information will be made, and it is also not possible to predict the outcome of litigation, inquiries or requests for information. It is possible that there could be unfavorable outcomes in these or other proceedings. Management is unable to make a meaningful estimate of the amount or range of loss that could result from unfavorable outcomes or of the expenses that will be incurred in defending these lawsuits. Under some circumstances, adverse results in any such proceedings and/or the incurring of significant litigation expenses could be material to our business, operations, financial position, profitability or cash flows.
The Settlement Agreement and Stipulation and Order contain restrictive covenants that may impair our ability to pursue our business strategies.
Pursuant to the terms of the Settlement Agreement and Stipulation and Order, Ambac Assurance must seek prior approval by OCI of certain corporate actions. The Settlement Agreement and Stipulation and Order also include covenants which restrict the operations of Ambac Assurance which, in the case of the Settlement Agreement, remain in force until the surplus notes that were issued pursuant to the Settlement Agreement have been redeemed, repurchased or repaid in full, and, in the case of the Stipulation and Order, remain in place until the OCI decides to relax such restrictions. Certain of these restrictions may be waived with the approval of holders of the surplus notes issued pursuant to the Settlement Agreement and/or OCI. If we are unable to obtain the required consents under the Settlement Agreement and/or Stipulation and Order, we may not be able to execute our planned business strategies.
OCI has certain enforcement rights with respect to the Settlement Agreement and Stipulation and Order. Disputes may arise over the interpretation of such agreements, the exercise or purported exercise of rights thereunder, or the performance of or failure or purported failure to perform obligations thereunder. Any such dispute could have material adverse effects on the Company, whether through litigation, administrative proceedings,
| Ambac Financial Group, Inc. 22 2017 FORM 10-K |
supervisory orders, failure to execute transactions sought by management, interference with corporate strategies, objectives or prerogatives, inefficient decision-making or execution, forced realignment of resources, increased costs, distractions to management, strained working relationships or otherwise. Such effects would also increase the risk that OCI would seek to initiate rehabilitation proceedings against Ambac Assurance.
System security risks, data protection breaches and cyber-attacks could adversely affect our business and results of operations.
We rely on our information technology systems for many enterprise-critical functions and a prolonged failure or interruption of these systems for any reason could cause significant disruption to our operations and have a material adverse effect on our business, financial condition and operating results. Our information technology and application systems may be vulnerable to threats from computer viruses, natural disasters, unauthorized access, cyber-attack and other similar disruptions. Computer hackers may be able to penetrate our network’s system security and misappropriate or compromise confidential information, create system disruptions or cause shutdowns. In addition to our own confidential information, we sometimes receive and are required to protect confidential information from third parties. To the extent any disruption or security breach results in a loss or damage to our data, or inappropriate disclosure of our confidential information or that of others, it could cause significant financial losses that are either not, or not fully, insured against, damage to our reputation, affect our relationships with third parties, lead to claims against us, result in regulatory action, or otherwise have a material adverse effect on our business or results of operations. In addition, we may be required to incur significant costs to mitigate the damage caused by any security breach, or to protect against future damage. Moreover, although we have disaster recovery and business continuity plans in place, we may not be able to adequately execute these plans in a timely fashion in the event of a disruption to our information technology and application systems.
We may incur losses resulting from operational risk due to inadequate or failed internal processes, breakdown of settlement or communication systems, or from external events leading to disruption of our business. Events subject to operational risk include:
Internal Fraud-misappropriation of assets, intentional mismarking of positions
External Fraud-theft of information, third-party theft and forgery
Clients, Products, & Business Practice-improper trade, fiduciary breaches
Damage to Physical Assets
Business Disruption & System Failures-software failures, hardware failures; and
Execution, Delivery, & Process Management-data entry errors, accounting errors, failed mandatory reporting, settlement errors, and negligence.
We may be adversely affected by failures in services or products provided by third parties.
We have outsourced and may continue to outsource certain activities of our operations and business, and rely upon third-party vendors for other essential services and information, such as the provision of data used in setting loss reserves and the provision of risk management information and services. A material failure by an external service or information provider or a material defect in the products, services or information provided thereby could adversely affect our financial condition and results of operations.
Our inability to attract and retain qualified executives and employees or the loss of any of these personnel could negatively impact our business.
Our ability to execute on our business strategies depend on the retention and recruitment of qualified executives and other professionals. We rely substantially upon the services of our current executive team. In addition to these officers, we require key staff with risk mitigation, structured finance, insurance, credit, investment, accounting, finance, legal and technical skills. As a result of Ambac’s financial situation, there is a higher risk that executive officers and other key staff will leave the Company and replacements may not be motivated to join the Company. The loss of the services of members of our senior management team or our inability to hire and retain other talented personnel could delay or prevent us from succeeding in executing our strategies, which could further negatively impact our business.
Our business could be negatively affected by actions of stakeholders whose interests may not be aligned with the broader interests of our stockholders.
Ambac could be negatively affected as a result of actions by stakeholders whose interests may not be aligned with the broader interests of our stockholders, and responding to any such actions could be costly and time-consuming, disrupt operations and divert the attention of management and employees. Such activities could interfere with our ability to execute on our strategic plans.
Risks Related to International Business
Actions of the PRA and FCA could reduce the value of Ambac UK realizable by Ambac, which would adversely affect our securityholders.
Ambac’s international business is operated by Ambac UK, which is regulated by the Prudential Regulation Authority (“PRA”) for prudential purposes and the Financial Conduct Authority (“FCA”) for conduct purposes. Under the Financial Services and Markets Act 2000 (“FSMA”), the PRA authorized Ambac UK to carry out financial guaranty insurance business in the UK and in the EU by way of the EU’s passporting regime (although this may change following Brexit), subject to the terms and conditions of the permission granted by the PRA and consented to by the FCA. However, the terms of Ambac UK’s regulatory authority are now restricted and Ambac UK is in run-off. Among other things, Ambac UK may not write any new business, and, with respect to any entity within the Ambac group of affiliates, commute, vary or terminate any existing financial guaranty policy, transfer certain assets, or pay dividends, without the prior approval of the PRA and FCA. The PRA and FCA act generally in the interests of Ambac UK policyholders and will not take into account the interests of securityholders of Ambac or Ambac Assurance when considering whether to provide any such approval. Accordingly,
| Ambac Financial Group, Inc. 23 2017 FORM 10-K |
determinations made by the PRA and FCA, in their capacity as Ambac UK’s regulator, could potentially result in adverse consequences for our securityholders and also reduce the value realizable by Ambac for Ambac UK.
Regulatory uncertainty in relation to Ambac UK’s capital position could adversely affect the value of Ambac UK and affect our securityholders.
Under applicable regulatory capital rules (“Solvency II”) Ambac UK remains significantly deficient in terms of capital. Ambac UK does not have a remedial plan other than to build its assets over time by on-going premium collections and earned investment income, as well as attempting to accelerate the run-off of its exposures. Further, there currently is no prospect of any capital support from the Ambac group of affiliates. The PRA is well aware of Ambac UK’s position and prospects. The PRA supervisory statement SS7/15 “Supervision of firms in difficulty or run-off” notes that “there are many circumstances in which a run-off strategy is in the best interests of policyholders” and notes that the PRA will review such firms and that they “may be permitted to continue activities necessary to carry out existing contracts in a manner, and for so long as, the PRA considers necessary in order to afford an appropriate degree of protection to policyholders”. AUK clearly falls into this category and therefore AUK’s current run off approach remains at all times subject to the PRA continuing to take no action in relation to its capital deficit and related Solvency II requirements. Alternative courses of action open to the PRA could adversely impact the anticipated run-off trajectory of Ambac UK and impact its value.
Uncertainty regarding the economic impact of “Brexit” may have an adverse effect on Ambac’s insured international portfolio and the value of its foreign investments, both of which primarily reside with its subsidiary Ambac UK.
In a non-binding referendum on the United Kingdom’s (“UK”) membership in the European Union (“EU”) in June 2016, a majority of those who voted approved the UK’s withdrawal from the EU. As a result of the referendum, in March 2017 the UK government gave the EU formal notification of its intent to leave with the expectation of formal withdraw two years later on 29 March 2019. Also in March 2017 the UK began initial (or phase one) negotiations with the EU regarding the terms of its departure (“Brexit”). On 8 December 2017 the EU and UK jointly announced, as set out in the Joint Report and Commission Communication of 8 December (“Joint Report”), that “sufficient progress” in phase one of the separation negotiations between the parties had been made to permit Brexit negotiations to move on to a more detailed phase two beginning in January 2018.
The Joint Report is “a summary of the negotiations toward the legally binding withdrawal agreement” and is not itself legally binding but rather is a position paper setting out current agreement between the EU and the UK Government in three priority areas (citizens’ rights, the financial settlement and the Irish border). It also notes progress on other separation issues that have not yet been settled. Further details of the negotiations are provided in the House of Commons Briefing Paper Number 8183, 18 December 2017.
While phase two Brexit separation discussions commenced in January 2018, these discussions will not include details of future, post-Brexit, trade relations. What is envisaged in the Joint Report
next is “an agreement as early as possible in 2018 on transitional arrangements”. A further, separate, mandate for negotiations on a future post-transition trade framework is anticipated to begin by summer 2018. It is envisaged negotiations on the future trade framework will be concluded during the actual transitional phase, and will be influenced by the nature of the transitional arrangements agreed between the parties.
If no transitional arrangements or new agreements are put into place, Brexit will mean that the activities in the EEA of UK passporting insurers will become unlawful on 29 March 2019. They will lose their legal authorization to serve clients who benefit from policies issued by a UK incorporated insurer under freedom of services passporting rights (and thereby maybe unable to legally collect premiums or pay claims) and if they have branches in EEA Member States they may be legally obliged to close them down and no longer be legally represented in those jurisdictions.
In light of the materiality of the insurance sector to the UK economy and taking into account the significant amount of insurance business undertaken by EEA based insurers in the UK (which will be similarly affected) it is expected that transition arrangements will be put in place leading to insurers being able to continue to service EU policies beyond 29 March 2019 for at least a transition period and likely to their natural run-off in relation to policies written prior to 29 March 2019. However, at this stage there is no certainly that such a transition agreement can be reached between the EU and the UK Government.
Ambac UK has seven policies in the EU written under current passporting rights the aggregate par value of which as at December 31, 2017 is $2.6 billion and as noted Ambac UK’s ability to service these contracts beyond 29 March 2019 is currently unclear until legally binding Brexit transition agreements are put into place prior to that date.
In addition to the direct impact on insurers cited above, general uncertainty and the perceptions as to the ultimate impact of Brexit may adversely affect business activity, political stability and economic conditions in the UK, the Eurozone, the EU and elsewhere. The economic outlook could be further adversely affected by (i) the risk that one or more other EU countries could come under increasing pressure to leave the EU, (ii) the risk of a greater demand for independence by Scottish nationalists or for unification in Ireland and its impact on the United Kingdom, or (iii) the risk that the Euro as the single currency of the Eurozone could cease to exist. Any of these developments, or the perception that any of these developments are likely to occur, could have a material adverse effect on economic growth or business activity in the UK, the Eurozone, and/or the EU, and could result in the relocation of businesses, cause business interruptions, lead to economic recession or depression, and impact the stability of the financial markets, the availability of credit, political systems or financial institutions and the financial and monetary system.
These economic conditions, particularly a recession or depression, may have a material adverse effect on Ambac’s international insured exposures particularly in the UK and Europe, the majority of which reside in Ambac UK. The creditworthiness of Ambac’s international insured exposures is subject to risks associated with, among other matters, lower asset values related to collateral backing transactions, depressed demand for services resulting in lower operating cash flows and reduced access to the capital
| Ambac Financial Group, Inc. 24 2017 FORM 10-K |
markets and other sources of financing or refinancing. In addition, such conditions may have a material adverse effect on the value and volatility of investments, including investments in UK property funds and equities that Ambac maintains, mainly through Ambac UK, in markets and currencies outside of the U.S. Collectively, these effects may have a negative impact on Ambac’s operating results and financial condition resulting from unexpected credit, investment and foreign exchange losses, volatile asset values, reduced liquidity and lost revenues.
The uncertainty concerning the timing and terms of the Brexit could result in additional volatility in the equity, foreign exchange, real property, bond and other markets, which could adversely impact the UK economy and Ambac's results of operations and financial condition over the near and long term.
Risks Related to Taxation
Certain surplus notes or other obligations of Ambac Assurance may be characterized as equity of Ambac Assurance and as a result, Ambac Assurance may no longer be a member of the U.S. federal income tax consolidated group of which Ambac is the common parent.
It is possible that certain surplus notes or other obligations of Ambac Assurance may be characterized as equity of Ambac Assurance for U.S. federal income tax purposes. If such surplus notes or other obligations are characterized as equity of Ambac Assurance that is taken into account for tax affiliation purposes and it is determined that such “equity” represented more than twenty percent of the total value of the stock of Ambac Assurance, Ambac Assurance may no longer be characterized as an includable corporation that is affiliated with Ambac. As a result, Ambac Assurance would no longer be characterized as a member of the U.S. federal income tax consolidated group of which Ambac is the common parent (the “Ambac Consolidated Group”) and Ambac Assurance would be required to file a separate consolidated tax return as the common parent of a new U.S. federal income tax consolidated group including Ambac Assurance as the new common parent and Ambac Assurance’s affiliated subsidiaries (the “Ambac Assurance Consolidated Tax Group”).
To the extent Ambac Assurance is no longer a member of the Ambac Consolidated Group, Ambac Assurance’s NOLs (and certain other available tax attributes of Ambac Assurance and the other members of the Ambac Assurance Consolidated Tax Group) may no longer be available for use by the Ambac Assurance Consolidated Tax Group or any of the remaining members of the Ambac Assurance Consolidated Tax Group to reduce the U.S. federal income tax liabilities of the Ambac Assurance Consolidated Tax Group. Ambac, Ambac Assurance and their affiliates entered into a tax sharing agreement that would require Ambac to make certain tax elections that could mitigate the loss of NOLs and other tax attributes resulting from a deconsolidation of Ambac Assurance from the Ambac Consolidated Group. However, in the event of a deconsolidation, certain other benefits resulting from U.S. federal income tax consolidation may no longer be available to the Ambac Consolidated Group including certain favorable rules relating to transactions occurring between members of the Ambac Consolidated Group and members of the Ambac Assurance Consolidated Tax Group.
If surplus notes or other obligations are characterized as equity of Ambac Assurance, the Ambac Assurance NOLs (and certain
other tax attributes or tax benefits of the Ambac Consolidated Group) may be subject to limitation under Section 382 of the Tax Code.
It is possible that certain surplus notes or other obligations may be characterized as equity of Ambac Assurance for U.S. federal income tax purposes. Such characterization could result in an “ownership change” of Ambac Assurance for purposes of Section 382 of the Tax Code. If such an ownership change were to occur, the value and amount of the Ambac Assurance NOLs would be substantially impaired, increasing the U.S. federal income tax liability of Ambac Assurance and materially reducing the value of Ambac Assurance’s stock owned by Ambac and the potential of future cash tolling or dividend payments from Ambac Assurance to Ambac.
Deductions with respect to interest accruing on certain surplus notes may be eliminated or deferred until payment.
To the extent certain surplus notes are characterized as equity for U.S. federal income tax purposes, accrued interest will not be deductible by Ambac Assurance. In addition, even if such surplus notes are characterized as debt for U.S. federal income tax purposes, the deduction of interest accruing on such surplus notes may be deferred until paid or eliminated in part depending upon (i) the terms of any deferral and payment provisions provided in such surplus notes, (ii) whether such surplus notes have “significant original issue discount,” and (iii) the yield to maturity of surplus notes. To the extent deductions with respect to interest are eliminated or deferred, the U.S. federal income tax of the members of the Ambac Consolidated Group or the members of the Ambac Assurance Consolidated Tax Group as the case may be, could be increased reducing the amount of cash available to pay its obligations.
Changes in Political or Economic Conditions
Implementation of the Tax Cuts and Jobs Act may have unexpected or adverse consequences for the Company and the value of its securities, particularly its common shares.
On December 22, 2017, new tax legislation, the Tax Cuts and Jobs Act, was signed into law. Amongst other things, the Tax Cuts and Jobs Act implemented a sweeping overhaul of the U.S. tax laws applicable to corporations. A major provision of the Tax Cuts and Jobs Act was a reduction of the maximum corporate federal income tax rate to 21% from 35%, which resulted in the Company reducing the value of its net deferred tax asset, the impact of which was offset by a change in valuation allowance. As a result of the reduction in the corporate federal tax rate, the maximum amount of future tolling payments AFG may receive from Ambac Assurance, for tax years beginning with 2018, will also be reduced to approximately $56 million from $97 million. The Tax Cuts and Jobs Act also requires U.S. corporations to pay federal income tax on previously untaxed foreign earnings accumulated under legacy tax laws included in income, for the last taxable year beginning before January 1, 2018. As a result of this and other provisions in the Tax Cuts and Jobs Act, Ambac Assurance is expected to make additional tax payments in 2017 related to alternative minimum tax, which will be refundable in the future. The aforementioned as well as other provisions of the Tax Cuts and Jobs Act, such as those relating to the limitations on the deductibility of interest expense, the Global Tax Intangible Low Taxed Income and Base Erosion Anti-Abuse Tax, may also have an adverse impact on Ambac Assurance’s and/or AFG’s future financial condition and results of
| Ambac Financial Group, Inc. 25 2017 FORM 10-K |
operations that is difficult to predict at this time. Any adverse impact or the perception of an adverse impact may cause the value of Ambac Assurance’s and/or AFG’s securities, particularly its common shares, to decline.
Risks Related to Strategic Plan
Ambac is exploring select business opportunities which may permit utilization of Ambac’s net operating loss carry-forwards; however, such business opportunities may not be consummated, or if consummated, may not create value and may negatively impact our financial results.
Ambac is exploring select business opportunities which may, amongst other things, permit utilization of its net operating loss carry-forwards. Such business opportunities, may involve the acquisition of assets or existing businesses or the development of businesses through new or existing subsidiaries. It is not possible at this time to predict the future prospects or other characteristics of any such business opportunities. Although we intend to conduct business, financial and legal due diligence in connection with the evaluation of any future business or acquisition opportunities, there can be no assurance our due diligence investigations will identify every matter that could have a material adverse effect on us. Efforts to pursue select business opportunities may be unsuccessful or require significant financial or other resources, which could have a negative impact on our financial condition. No assurance can be given that Ambac will be able to complete such business opportunities, generate any earnings or be able to successfully integrate any such business into our current operating structure.
Moreover, Ambac’s ability to enter new businesses, including new businesses apart from Ambac Assurance, is also subject to significant doubt, given the financial condition of Ambac Assurance, the difficulty of leveraging or monetizing Ambac’s other assets, and the uncertainty of its ability to raise capital. Due to these factors, as well as those relating to Ambac Assurance as described in this Item 1A. Risk Factors, the value of our securities is speculative.
Ambac’s current strategy and initiatives have been derived from, and created as a consequence of, the company’s current financial condition and circumstances. Should changes in Ambac’s circumstances or financial condition or in the political, economic and/or legal environment occur, there can be no assurances that all or any part of such strategy and/or initiatives will not be abandoned or amended to take account of such changes. Any such adjustment or abandonment may have an adverse effect on our securities.
Item 1B. Unresolved Staff Comments
Item 2. Properties
The executive office of Ambac is located at One State Street Plaza, New York, New York 10004, which consists of 103,484 square feet of office space, under lease agreements that expire in September 2019 (77,613 square feet) and December 2029 (25,871 square feet). The lease expiring in September 2019 has a provision that can extend the lease to December 2029. Ambac leases additional space outside of New York for its data center at a secure facility under a lease agreement that expires in March 2019.
Ambac UK maintain an office in London, England, which consist of 3,514 square feet of office space, under a lease agreement that expires in October 2020.
Additionally, Ambac maintains a disaster recovery site as part of its Disaster Recovery Plan, which is located approximately 100 miles from One State Street Plaza under a lease that expires in September 2019. This remote warm-back-up facility is complete with user work stations, phone system, data center, internet connectivity and a power generator, capable of serving the needs of the disaster recovery team to support all business operations. The plan, facility and systems are revised and upgraded where necessary, and user tested annually to confirm their readiness.
Item 3. Legal Proceedings
Refer to Notes to the Consolidated Financial Statements—Note 16. Commitments and Contingencies included in Part II, Item 8 in this Form 10-K for a discussion on legal proceedings against Ambac and its subsidiaries.
Item 4. Mine Safety Disclosures
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
The Company's common stock is listed on NASDAQ under the symbol “AMBC.” The high and low common stock prices per share were as follows:
On February 27, 2018, there were 29 stockholders of record of Ambac’s common stock.
The Company did not pay cash dividends on its common stock during 2017 and 2016. Information concerning restrictions on the payment of dividends from Ambac's insurance subsidiaries is set forth in Item 1 above under the caption “Dividend Restrictions, Including Contractual Restrictions" and in Note 8. Insurance Regulatory Restrictions to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K.
Purchases of Equity Securities By the Issuer and Affiliated Purchasers
There were no repurchases of equity securities during the fourth quarter of 2017. Ambac does not have a stock repurchase program.
| Ambac Financial Group, Inc. 26 2017 FORM 10-K |
On June 30, 2015, the Board of Directors of Ambac authorized the establishment of a warrant repurchase program that permits the repurchase of up to $10 million of warrants. On November 3, 2016, the Board of Directors of Ambac authorized an additional $10 million to the warrant repurchase program. As of December 31,
2017, Ambac had repurchased 985,331 warrants at a cost of $8.1 million, leaving 4,053,670 warrants outstanding with an exercise price of $16.67 per share and expiration of April 30, 2023. The remaining aggregate authorization at December 31, 2017 is $11.9 million.
Stock Performance Graph
The following graph compares the performance of an investment in our common stock from the close of business on May 1, 2013, the date we emerged from bankruptcy through December 31, 2017, with the Russell 2000 Index and S&P Completion Index. The graph assumes $100 was invested on May 1, 2013 in our common Stock at the closing price of $20 per share and at the closing price for the Russell 2000 Index and S&P Completion Index. It also assumes that dividends (if any) were reinvested on the date of payment without payment of any commissions. The performance shown in the graph represents past performance and should not be considered an indication of future performance.
Ambac Financial Group, Inc.
Russell 2000 Index
S&P Completion Index
| Ambac Financial Group, Inc. 27 2017 FORM 10-K |
Item 6. Selected Financial Data
The following financial information for the five years ended December 31, 2017, has been derived from Ambac’s Consolidated Financial Statements. Following Ambac’s emergence from bankruptcy on May 1, 2013, the consolidated financial statements reflect the application of fresh start reporting (“Fresh Start”), incorporating, among other things, the discharge of debt obligations, issuance of new common stock and fair value adjustments. The effects of the reorganization and Fresh Start adjustments are recorded in Predecessor Ambac’s Consolidated Statement of Total Comprehensive Income for the period ended April 30, 2013. The financial results of the Company for the periods from May 1, 2013 are referred to as “Successor” and the financial results for the periods through April 30, 2013 are referred to as “Predecessor”. The 2013 Successor Period and the 2013 Predecessor Period are distinct reporting periods. As a result of the implementation of Fresh Start, results and balances are not comparable between Successor Ambac and Predecessor Ambac. This information should be read in conjunction with the Consolidated Financial Statements and related notes located in Part II, Item 8 in this Form 10-K.
Year Ended December 31,
($ in millions, except per share data)
Total Comprehensive Income Highlights:
Gross premiums written
Net premiums earned
Net investment income
Other than temporary impairment losses
Net realized investment gains
Net change in fair value of credit derivatives
Net gains (losses) on interest rate derivatives
Net realized (losses) gains on extinguishment of debt
Income (loss) on Variable Interest Entities ("VIEs")
Losses and loss expenses (benefit) (1)
Interest and underwriting and operating expenses
Insurance intangible amortization
Pre-tax income (loss)
Net income (loss) attributable to Common Shareholders
Total comprehensive income attributable to Ambac Financial Group, Inc.
Net income (loss) per share:
Ambac records the impact of estimated recoveries related to securitized loans in RMBS transactions that breached certain representations and warranties within losses and loss expenses (benefit). The expense (benefit) associated with changes to our estimated recoveries for the years ended December 31, 2017, 2016, 2015 and 2014, the eight months ended December 31, 2013 and the four months ended April 30, 2013 were $72.0 million, $(71.4) million, $(303.6) million, $(481.7) million, $199.4 million, and $(61.6) million, respectively.
| Ambac Financial Group, Inc. 28 2017 FORM 10-K |
($ in millions) December 31
Balance Sheet Highlights:
Total non-variable interest entity investments
Cash and cash equivalents
Insurance intangible asset
Subrogation recoverable (1)
Deferred ceded premium
Total VIE assets
Losses and loss expense reserve (1)
Obligations under investment agreements
Long-term debt (2)
Total VIE liabilities
Total stockholders’ equity
Total liabilities and stockholders' equity
Ambac records as a component of its loss reserves and subrogation recoverable, estimated recoveries related to securitized loans in RMBS transactions that breached certain representations and warranties. Ambac has recorded gross estimated recoveries of $1,834.4 million, $1,907.0 million, $2,829.6 million, $2,523.5 million and $2,206.6 million at December 31, 2017, 2016, 2015, 2014 and 2013, respectively.
Long-term debt represents surplus notes issued to third parties by Ambac Assurance and the Segregated Account and secured borrowing obligations. In 2014, Ambac sold a $350.0 million junior surplus note issued to it by the Segregated Account to a newly formed Trust in exchange for cash of $224.3 million and a subordinated owner trust certificate issued by the Trust. Long-term debt for all years excludes the portion of long-term debt associated with variable interest entities. In 2015, Ambac entered into a $146.0 million secured borrowing transaction.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
This Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) contains certain financial measures, in particular the presentation of Adjusted Earnings and Adjusted Book Value, which are not presented in accordance with accounting principles generally accepted in the United States (“GAAP”). We are presenting these non-GAAP financial measures because they provide greater transparency and enhanced visibility into the underlying drivers of our business. We do not intend for these non-GAAP financial measures to be a substitute for any GAAP financial measures and they may differ from similar reporting provided by other companies. Readers of this Form 10-K should use these non-GAAP financial measures only in conjunction with the comparable GAAP financial measures. Adjusted Earnings and Adjusted Book Value are non-GAAP financial measures that adjust for the impact of certain non-recurring or non-economic GAAP accounting requirements and include certain items that the Company has or expects to realize in the future, but that are not reported under GAAP. We also provide reconciliations to the most directly comparable GAAP measures; Adjusted Earnings to Net income attributable to common stockholders and Adjusted Book Value to Total Ambac Financial Group, Inc. stockholders’ equity.
See Note 1. Background and Business Description for a description of the Company and our key strategies to achieve our primary goal to maximize shareholder value.
Ambac Assurance and Subsidiaries:
A key strategy for Ambac is to increase the value of its investment in Ambac Assurance by actively managing its assets and liabilities. Asset management primarily entails maximizing the risk adjusted return on non-VIE invested assets and managing liquidity to help ensure resources are available to meet operational and strategic cash needs. These strategic cash needs include activities associated with Ambac's liability management and loss mitigation programs. Management evaluates the potential impact of loss mitigation and
avoidance strategies in order to target and prioritize policies, or portions thereof, for commutation, refinancing, restructuring or other risk reduction or defeasance strategies.
Investment portfolios are subject to internal investment guidelines, as well as limits on types and quality of investments imposed by applicable insurance laws and regulations. As part of its investment strategy, and in accordance with the aforementioned guidelines, Ambac Assurance and Ambac Assurance UK Limited ("Ambac UK"), purchase distressed Ambac-insured securities based on their relative risk/reward characteristics. The investment portfolios of Ambac Assurance and Ambac UK also hold fixed income securities and funds that include a variety of other assets including, but not limited to, corporate bonds, asset backed and mortgage backed securities, municipal bonds, high yield bonds, leveraged loans, equities, real estate, insurance-linked securities and hedge
| Ambac Financial Group, Inc. 29 2017 FORM 10-K |
funds. Refer to Note 10. Investments to the Consolidated Financial Statements, included in Part II, Item 8 in this Form 10-K for further details of fixed income investments by asset class.
During the year ended December 31, 2017, Ambac (inclusive of its subsidiaries) acquired $815.2 million of distressed Ambac-insured securities, including $97.3 million of RMBS and $686.1 million of Puerto Rico securities. Future cash flows relating to those invested assets include the sum of (i) the bond’s intrinsic cash flows and (ii) the estimated Ambac claim payments. At December 31, 2017, Ambac owned $2,242.3 million Ambac-insured RMBS, which included approximately $1.6 billion, or 41% of the total Deferred Amounts (as defined in the Segregated Account Rehabilitation Plan) outstanding were attributable, and approximately 29% of PRIFA and 58% of COFINA Ambac-insured bonds. Subject to applicable internal and regulatory guidelines and other constraints, Ambac will continue to opportunistically purchase Ambac-insured securities.
Liability and Insured Exposure Management:
Ambac Assurance's Risk Management Group focuses on the analysis, implementation and execution of commutations, risk reduction or defeasance and loss recovery strategies. Analysts evaluate the estimated timing and severity of projected policy claims as well as the potential impact of loss mitigation or remediation strategies in order to target and prioritize policies, or portions thereof, for commutation, refinancing, restructuring or other risk reduction or defeasance strategies. For targeted policies, analysts will engage with bondholders, issuers and other economic stakeholders to negotiate, structure and execute such strategies. During the 2017, Ambac's successes included:
On March 25, 2017, Ambac UK agreed in principle to a confidential settlement of litigation brought by Ambac UK in the name of Ballantyne Re plc (“Ballantyne”) against J.P. Morgan Investment Management Inc. (“JPMIM”) relating to the management of Ballantyne’s investment accounts, which were funded with the proceeds of notes issued in 2006 in connection with a structured reinsurance transaction and guaranteed in part by Ambac UK. On April 11, 2017, Ambac UK, Ballantyne and JPMIM signed a settlement agreement. Pursuant to the settlement, Ballantyne received a payment in return for releases of all claims by Ballantyne and Ambac UK. Ambac realized a US GAAP benefit through losses and loss expenses of approximately $91.6 million in 2017 as a result of the settlement, which resulted from the reduction of loss and loss expense reserves previously established in relation to Ballantyne, and not from a direct cash payment to Ambac UK.
On June 27, 2017, Ambac Assurance entered into a termination agreement with various parties, including a special purpose entity Augusta Funding Limited IV ("Augusta"), in connection with the commutation of an interest rate swap between Augusta and Ambac Assurance's wholly-owned subsidiary, Ambac Financial Services ("AFS"). During the second quarter, AFS made net settlement payments of approximately $103.6 million, including $94.4 million under the termination agreement. At March 31, 2017, Ambac had recorded a mark-to-market liability under this swap transaction of $147.0 million (net of an Ambac Assurance CVA of $42.9 million), resulting in a gain of
approximately $43.4 million during 2017. In July 2017, Augusta redeemed its outstanding Ambac Assurance-insured debt and Ambac recognized approximately $2.6 million in accelerated premiums in 2017 relating to this redemption. The Ambac-insured Augusta net par outstanding was $185 million at the time of redemption and was adversely classified.
Ambac U.K. worked to facilitate an international asset-backed issuer's refinancing of £188.1 million of insured debt and which paid Ambac UK a termination premium of £12.6 million, resulting in accelerated premiums earned of $11.2 million in 2017;
Ambac worked closely with servicers and owners of Master Servicing Rights to exercise clean-up calls on 20 RMBS transactions, resulting in a benefit in losses and loss expenses of $21.8 million and reducing adversely classified net par exposure by $422.5 million;
Ambac Assurance commuted its policy on a long time distressed municipality ($44.6 million of net par exposure); aided in the refinancing of more than 50% ($144.7 million of net par exposure) of its exposure to Chicago, IL Board of Education general obligation bonds, resulting in an aggregate losses and loss expenses benefit of $4.1 million; and negotiated with a distressed domestic asset-backed VIE that was previously consolidated by Ambac to settle all of their assets and refinance its Ambac-insured debt ($30.8 million of net par exposure).
During 2017, Ambac Assurance purchased the remaining $4.0 million of unpaid accrued interest related to certain surplus notes that were previously repurchased under call options. Ambac recognized a realized gain on these purchases of $1.1 million in the Consolidated Statements of Total Comprehensive Income (Loss).
On February 12, 2018, the Second Amended Plan of Rehabilitation of the Segregated Account became effective and Ambac and Ambac Assurance consummated a series of transactions that generally involved (i) the exchange of certain surplus notes held by holders of surplus notes that elected to participate in a voluntary exchange transaction and (ii) the satisfaction and discharge of all Deferred Amounts of the Segregated Account, in each case for an effective consideration package comprised of cash, new Secured Notes and certain existing surplus notes and (iii) the exit from rehabilitation of the Segregated Account (the “Rehabilitation Exit Transactions”). See Note 1. Background and Business Description to the Consolidated Financial Statements, included in Part II, Item 8 in this Form 10-K for details regarding the Rehabilitation Exit Transactions.
The following table provides a comparison of total and adversely classified credits ("ACC") net par outstanding in the insured portfolio at December 31, 2017 and 2016. Net par exposures within the U.S. public finance market includes capital appreciation bonds which are reported at the par amount at the time of issuance of the insurance policy as opposed to the current accreted value of the bonds.
| Ambac Financial Group, Inc. 30 2017 FORM 10-K |
($ in billions)
The overall reduction in total net par outstanding resulted from scheduled maturities, amortizations, commutations, refundings, refinancings and calls, including reductions as a result of the activities of Ambac and its subsidiaries as noted above.
The decrease in adversely classified credit exposures are primarily due to (i) calls, refundings, and paydowns or negotiated refinancings and commutations with a large portion of the decrease related to residential mortgage-backed securities and (ii) the upgrade of several remediated public finance transactions, partially offset by (iii) the downgrades of a Military Housing transaction and an Italian sub-sovereign transaction. Although our insured portfolio generally performed satisfactorily in 2017, we continued to experience stress in certain sectors and insured exposures, most notably within our approximately $2.0 billion of exposure to Puerto Rico consisting of several different issuing entities (all adversely classified). Each Puerto Rico issuing entity has its own credit risk profile attributable to discreet revenue sources, direct general obligation pledges and/or general obligation guarantees. Refer to "Financial Guarantees in Force" below in this Management Discussion and Analysis regarding the different issuing entities that encompass Ambac's exposures to Puerto Rico.
In 2017, Ambac established a new non-adversely classified credit category of watch list. Watch list credits are currently fully performing but demonstrate the potential for future material adverse development due to such factors as long-term uncertainty about a particular sector, a certain structural element related to the issuer or transaction, or overall financial and economic sustainability. Total net par exposures of watch list credits are $11.1 billion at December 31, 2017.
As of December 31, 2017 total cash and investments of Ambac were $368.2 million, which include the following:
Asset backed and short-term securities of $96.3 million
Ambac-insured securities with a fair value of $5.9 million
Ambac Assurance surplus notes with a fair value of $201.3 million, which are eliminated in consolidation
Residual equity interest in the Corolla Trust that was created in 2014 to monetize Ambac's ownership interest in junior surplus notes issued by the Segregated Account. Ambac carries this interest using the equity method. Additionally, at December 31, 2017 Ambac held $35.0 million par amount of the debt issued by this VIE. The total carrying value of Ambac's equity and debt interests in Corolla Trust was $64.7 million at December 31, 2017. Refer to Note 3. Special Purpose Entities, Including Variable Interest Entities to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K, for more information on the Corolla Trust.
During 2017, Ambac purchased ($101.8 million) and exchanged Ambac-insured bonds (fair value of $79.3 million) to extinguish
(on a consolidated basis) $108.1 million par of Ambac Assurance surplus notes and $39.1 million par of Segregated Account surplus notes. Ambac recognized $3.8 million of gains on the extinguishment of debt in the Consolidated Statements of Income (Loss) as a result of these transactions during the year ended December 31, 2017.
As a result of positive taxable income at Ambac Assurance in 2016, Ambac received $28.7 million in tax tolling payments in May 2017. As a result of filing its 2016 tax return, Ambac received an additional $0.6 million of tolling payments in December 2017. For the year ended December 31, 2017, $30.5 million of tolling payments were accrued which are expected to be paid to Ambac no later than forty-five days after April 15, 2018. There are no assurances that Ambac Assurance will be able to generate taxable income and therefore make tolling payments to Ambac in the future, which may ultimately constrain Ambac's access to capital and liquidity to support it operations and strategic initiatives.
Financial Statement Impacts of Foreign Currency:
The impact of foreign currency as reported in Ambac's Consolidated Statement of Total Comprehensive Income for the year ended December 31, 2017 included the following:
($ in millions)
Net income (1)
Changes in other comprehensive income:
Gain (losses) on foreign currency translation
Unrealized gains (losses) on non-functional currency available-for-sale securities
Total changes in other comprehensive income
Impact on total comprehensive income (loss)
A portion of Ambac UK's, and to a lesser extent Ambac Assurance's, assets and liabilities are denominated in currencies other than its functional currency and accordingly, we recognized net foreign currency transaction gains/(losses) as a result of changes to foreign currency rates through our Consolidated Statement of Total Comprehensive Income (Loss). Refer to Note 2. Basis of Presentation and Significant Accounting Policies to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K for further details on transaction gains and losses.
Future changes to currency rates may adversely affect our financial results. Refer to Part II, Item 7A "Quantitative and Qualitative Disclosures about Market Risk" for further information on the impact of future currency rate changes on Ambac's financial instruments.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Ambac's Consolidated Financial Statements have been prepared in accordance with GAAP. This section highlights accounting estimates management views as critical because they require management to make difficult and subjective judgments regarding matters that are inherently uncertain and subject to change. These estimates are evaluated on an on-going basis based on historical developments, market conditions, industry trends and other information that is reasonable under the circumstances. There can be no assurance that actual results will conform to estimates and that reported results of operations will not be materially adversely affected by the need to make future accounting adjustments to reflect changes in these estimates from time to time.
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Management has identified the following critical accounting policies and estimates: (i) valuation of loss and loss expense reserves, (ii) valuation of certain financial instruments and (iii) valuation of deferred tax assets. Management has discussed each of these critical accounting policies and estimates with the Audit Committee, including the reasons why they are considered critical and how current and anticipated future events impact those determinations. Additional information about these policies can be found in Note 2. Basis of Presentation and Significant Accounting Policies to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K.
Valuation of Losses and Loss Expense Reserves:
The loss and loss expense reserves ("loss reserves") discussed in this section relate only to Ambac’s non-derivative insurance policies issued to beneficiaries, including unconsolidated VIEs. Ambac's loss reserves include loss reserve components of an insurance policy, including unpaid claims and the present value ("PV") of expected net cash flows required to be paid under an insurance contract. Unpaid claims, which include accrued interest, represent claims that were not paid for policies allocated to the Segregated Account. The PV of expected net cash flows represents the PV of expected cash outflows less the PV of expected cash inflows discounted at a risk-free discount rate. While unpaid claims are known and therefore not a subjective estimate, expected future losses, net of expected future recoveries, are inherently uncertain. As such, the remaining discussion is limited to addressing expected future losses, net of expected future recoveries.
The evaluation process for expected future losses is subject to certain estimates and judgments regarding the probability of default by the issuer of the insured security, probability of remediation and settlement outcomes (which may include commutation, litigation settlements, refinancings and/or other settlement outcomes), probability of a restructuring outcome (which may include payment moratoriums, debt haircuts and/or
subsequent recoveries) and the expected loss severity of credits for each insurance contract.
As the probability of default for an individual credit increases and/or the severity of loss given a default increases, our loss reserve for that insured obligation will also increase. Political, economic, credit or other unforeseen events could have an adverse impact on default probabilities and loss severities. The loss reserves for many transactions are derived from the issuer’s creditworthiness. For public finance issuers, loss reserves will consider not only creditworthiness but also political dynamics and economic status and prospects. The loss reserves for other transactions which have no direct issuer support, such as most structured finance exposures, including RMBS and student loan exposures, are derived from the default activity and loss given default of underlying collateral supporting the transactions. In addition, many transactions have a combination of issuer/entity and collateral support. Loss reserves reflect our assessment of the transaction’s overall structure, support and expected performance. Loss reserve volatility will be a direct result of the credit performance of our insured portfolio, including the number, size, bond types and quality of credits included in our loss reserves as well as our ability to execute workout strategies and commutations. The number and severity of credits included in our loss reserves depend to a large extent on transaction specific attributes, but will generally increase during periods of economic stress and decline during periods of economic prosperity. Reinsurance contracts mitigate our loss reserve but since Ambac has little exposure ceded to reinsurers, the existing reinsurance contracts are unlikely to have a significant effect on loss reserve volatility. However, entrance into new reinsurance contracts may impact loss reserve volatility. Loss reserve volatility will also be materially impacted by changes in interest rates from period to period.
The table below indicates the gross par outstanding and gross loss reserves (including loss expenses) related to policies in Ambac’s loss and loss expense reserves at December 31, 2017 and 2016:
($ in millions) December 31
Gross Loss and Loss Expense
Gross Loss and Loss Expense
Domestic Public Finance
All other credits
Ceded par outstanding on policies with loss reserves and ceded loss and loss expense reserves are $590 and $41, respectively, at December 31, 2017 and $607 and $31, respectively at December 31, 2016. Ceded loss and loss expense reserves are included in Reinsurance recoverable on paid and unpaid losses.
Gross Par Outstanding includes capital appreciation bonds, which are reported at the par amount at the time of issuance of the insurance policy as opposed to the current accreted value of the bond.
Loss and Loss Expense reserves at December 31, 2017 of $4,114 are included in the balance sheet in the following line items: Loss and loss expense reserves: $4,745 and Subrogation recoverable: $631. Loss and Loss Expense reserves at December 31, 2016 of $3,696 are included in the balance sheet in the following line items: Loss and loss expense reserves: $4,381 and Subrogation recoverable: $685.
Included in Gross Loss and Loss Expense Reserves are unpaid claims of $3,867 and $3,656 at December 31, 2017 and 2016, respectively, related to policies allocated to the Segregated Account, inclusive of accrued interest payable on Deferred Amounts of $840 and $662, respectively.
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Ambac records as a component of its loss and loss expense reserves, estimated recoveries related to securitized loans in RMBS transactions that breached certain representations and warranties. Ambac has recorded gross estimated recoveries of $1,834 and $1,907 at December 31, 2017 and 2016, respectively.
See Note 2. Basis of Presentation and Significant Accounting Policies for a description of the cash flow and statistical methodologies used to develop loss reserves. Most of our reserved credits with large loss reserves utilize the cash flow method of reserving. Alternative cash flow scenarios are developed to represent the range of possible outcomes and resultant future claims payments and timing. Scenarios and probabilities are adjusted regularly to reflect changes in status, outlook and our analysis and views. Significant judgment is used to develop the cash flow assumptions, and there can be no certainty that the modeled scenarios or probabilities will not deviate materially from ultimate outcomes.
In some cases, such as RMBS and student loans, which are described more fully below, cash flow projections include the modeling of an issuer or transaction’s future revenues and expenses to determine the resources available to pay debt service on our insured obligations. In other cases, such as many public finance exposures including our Puerto Rico exposures, we do not specifically forecast resources available to pay debt service in the cash flow model itself. Rather, we consider the issuers’ overall ability and willingness to pay, including the existing fiscal, economic, legal and political framework. We then develop multiple scenarios where issuer debt service is paid, missed and/or haircut with claims paid then modeled for any recovery amount and timing. In our experience, this has been an effective approach to loss reserving these types of credits, but there is no certainty our assumptions as to scenarios or probabilities will not be subject to material changes as developments occur or that this method will be as effective in the future as it has been in the past.
In estimating loss reserves, we also incorporate scenarios which represent the potential outcome of remediation strategies. Remediation scenarios may include the following; (i) a potential refinancing of the transaction by the issuer; (ii) the issuer’s ability to redeem outstanding securities at a discount, thereby increasing the structure’s ability to absorb future losses; and (iii) our ability to terminate or restructure the policy in whole or in part (e.g., commutation). The remediation scenarios and the related probabilities of occurrence vary by policy depending on on-going and expected discussions and negotiations with issuers and/or investors. In addition to commutation negotiations that are underway with various counterparties in various forms, our reserve estimates may also include scenarios which incorporate our ability and/or expectation to commute additional exposure with other counterparties.
RMBS Expected Loss Estimate
Ambac insures RMBS transactions collateralized by first-lien mortgages. Ambac classifies its insured first-lien RMBS exposure principally into two broad credit risk classes: mid-prime (including Alt-A, interest only, and negative amortization) and sub-prime. Mid-prime loans were typically made to borrowers who had credit profiles stronger than sub-prime loans, but weaker than prime loans. Compared with mid-prime loans, sub-prime loans typically had higher loan-to-value ratios, reflecting the greater difficulty that sub-prime borrowers have in making down payments and the propensity of these borrowers to extract equity during refinancing.
Ambac has also insured RMBS transactions collateralized predominantly by second-lien mortgage loans such as closed-end seconds and home equity lines of credit. A second-lien mortgage loan is a type of loan in which the borrower uses the equity in their home as collateral and the second-lien loan is subordinate to the first-lien loan outstanding on the home. Borrowers are obligated to make monthly payments on both their first and second-lien loans. If the borrower defaults on the payments due under these loans and the property is subsequently liquidated, the liquidation proceeds are first utilized to pay off the first-lien loan (as well as other costs) and any remaining funds are applied to pay off the second-lien loan. As a result of this subordinate position to the first-lien loan, second-lien loans carry a significantly higher severity in the event of a loss, approaching or exceeding 100%.
Ambac primarily utilizes a statistically based cash flow model (“RMBS cash flow model”) to develop estimates of projected losses for both our first and second lien transactions. The RMBS cash flow model projects collateral performance utilizing: (i) the transaction’s underlying loans' characteristics and status, (ii) projected home price appreciation (“HPA”) and (iii) projected interest rates. We source HPA projections from a market accepted vendor and interest rate projections are developed from market sources. We generally utilize waterfall projections from a market accepted vendor which models securitization deal structures. In some cases, we may utilize an alternative waterfall structure when our legal and commercial analysis of the transaction’s payment structure differs from the vendor’s waterfall structure.
We compare monthly claims submitted against the trustees’ reports, third-party provided waterfall projections and our understanding of the transactions’ structures to identify and resolve discrepancies. We also systematically review the vendor’s published waterfall revisions to further identify material discrepancies. Resolving discrepancies is challenging and may take place over an extended period of time. Moreover, transaction documents are subject to interpretation, and our interpretation or that of the vendor and as reflected in our loss reserves may prove to be incorrect and/or not consistent with trustees directing cash flows in the future.
In our experience, market performance and model characteristics change and therefore need to be updated and reflected in our models through time. As such, we conduct regular reviews of current models, alternative models and the overall approach to loss estimation. In particular, the RMBS cash flow model is subject to ongoing refinements and/or replacement resulting from industry research as well as performance analysis that may better inform model assumptions, improvements to modeling capabilities and approaches and other factors.
The RMBS cash flow model estimates mortgage loan collateral performance, the effect of such collateral cash flows within the transaction waterfall and the liability structure we insure. Collateral performance is frequently modeled at the deal level given the paucity of mortgage loan level data for second-lien transactions. In the absence of specific loan-level information, the deal-level approach evaluates a loan pool as if it were a single loan,
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selecting certain aggregated deal-level characteristics to then perform a series of statistical analyses. We use three HPA projection scenarios to develop a base case as well as stress and upside cases. The highest probability is assigned to the base case, with lower probabilities to the stress and upside cases. This deal-level approach takes relatively complicated monthly collateral performance and divides it into two parts: a borrower-behavior-dependent stage and a servicer-behavior-dependent stage.
The borrower-behavior-dependent stage is designed to forecast the probability of a loan’s present delinquency status transitioning to any of eight future statuses. The deal-level approach projects performance using a roll-rate that evaluates the possible future state of a loan based on its current status and three variables: average FICO (credit score), average current consolidated loan to value ratio (“CLTV”) and an overall quality indicator. The servicer-behavior-dependent stage governs a loan’s life cycle after it reaches 180 or more days delinquent. This stage evaluates the servicer’s propensity to foreclose or pursue a short sale, the speed of the foreclosure process, and the speed of the post-foreclosure distressed property liquidation. The transition probabilities between stages are assumed by the model to depend upon how long a loan has already been in a particular status, as well as on the servicer-specific and state-specific liquidation (e.g., a judicial or statutory foreclosure state) timeline factors.
For most first-lien transactions, the RMBS cash flow model utilizes mortgage loan level data from recognized market sources to calculate probability of default and prepayment based on loan characteristics. The loan-level approach of the RMBS cash flow model uses results of a regression analysis to project prepayment and default vectors on a monthly basis. For first-lien transactions that do not have loan-level data available, we use the deal-level approach of the model that is described in the Second-Lien section above.
There are three general stages with the loan-level approach of the model: current, prepayment or default. The model then looks beyond the stages to assess a set of loans based on a number of individual characteristics that are distinct to that set of loans. The model will project performance based on the borrower’s given probability of transitioning that month. Servicer behavior is a variable in the loan-level approach; computing the impact of servicing on the associated collateral. Consistent with the second-lien modeling, we consider three HPA scenarios in the RMBS cash flow model to develop a base case as well as stress and upside cases. The highest probability is assigned to the base case, with lower probabilities to the stress and upside cases.
Other RMBS Factors:
Additional factors that may impact ultimate RMBS second-lien and first-lien losses include, but may not be limited to, mortgage insurance, servicer intervention and third-party settlements.
Mortgage insurance: Three of our mortgage-backed transactions have active pool-level mortgage insurance; which consists of a master policy issued to the mortgage securitization trust that indemnifies the trust either on a first loss or mezzanine basis in the event that covered mortgage loans in the trust default. The mortgage insurance master policy includes various conditions such as exclusions, conditions for notification of loans in default and
claims settlement. We have noted with regard to these securitization trusts, payments by mortgage insurers of claims presented by the securitization trusts have been inconsistent, resulting in higher claims presented under Ambac Assurance’s financial guarantee policies. The pool-level mortgage insurance has a negligible benefit to loss reserves for the remaining three transactions with pool-level mortgage insurance.
Servicer Intervention: We include in our modeling the steps which Ambac is taking to address shortcomings in servicing performance. Ambac has initiated programs with selected servicers that we believe will mitigate losses on such transactions through intervention strategies such as loan modifications, improved liquidation timelines and short sales. Ambac believes these are the principal controllable factors that will result in reduced losses over time. Given the uncertainty in initiating additional programs of this nature, we give credit in our models only on exposures that have already transferred servicing or entered into special servicing agreements.
Third party settlements: To the extent that we are aware of settlements between issuers and investors or trustees which may provide for recoveries within certain insured RMBS trusts, we have incorporated in our modeling of collateral losses our estimate of the probable amount and timing of these settlements.
Expected Representation and Warranty Subrogation Recoveries
Ambac records as a component of its loss reserve estimate subrogation recoveries related to securitized loans in RMBS transactions that breached certain representations and warranties ("R&W") described herein. Generally, the sponsor of an RMBS transaction provided representations with respect to the securitized loans, including representations with respect to the loan characteristics, the absence of borrower fraud in the underlying loan pools or other misconduct in the origination process and attesting to the compliance of loans with the prevailing underwriting policies. In such cases, the sponsor of the transaction is contractually obligated to repurchase, cure or substitute collateral for any loan that breaches the representations or warranties
The RMBS R&W subrogation recovery estimate is subject to significant uncertainty, including risks inherent in litigation, collectability of such amounts from counterparties and/or their respective parents and affiliates, timing of receipt of any such recoveries, intervention by OCI which could impede our ability to take actions required to realize such recoveries and uncertainties inherent in the assumptions used in estimating such recoveries. Refer to Note 2. Basis of Presentation and Significant Accounting Policies and Note 7. Financial Guarantee Insurance Contracts to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K for more information regarding the estimation process for representation and warranty subrogation recoveries.
Student Loan Expected Loss Estimate
The student loan portfolio consists of credits collateralized by private student loans. The calculation of loss reserves for our student loan portfolio involves evaluating numerous factors that can impact ultimate losses. The factor which contributes the greatest degree of uncertainty in ascertaining appropriate loss reserves is the long final legal maturity date of the insured bonds. Most of the student loan bonds which we insure were issued with
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original terms of 20 to 40 years until final maturity. Since our policy covers timely interest and ultimate principal payment, our loss projections must make assumptions for many factors covering a long time horizon. Key assumptions that will impact ultimate losses include, but are not limited to, the following: collateral performance (which is highly correlated to the economic environment), interest rates, operating risks associated with the issuer, servicers, special servicers, and administrators, investor appetite for tendering or commuting insured obligations and, as applicable, Ambac’s ability and willingness to commute policies. In addition, we consider in our student loan loss projections the potential impact, if any, of proposed or final regulatory actions or orders, including by the Consumer Financial Protection Bureau ("CFPB"), affecting our insured transactions.
In evaluating our student loan portfolio, our losses are projected using a cash flow modeling approach. In order to project collateral performance under the cash flow approach, we use an internally developed default projection tool that constructs lifetime cohort default curves based on loan and deal-level historical performance data. To determine ultimate losses on the transactions, the cohort default curves are used to extrapolate future default behavior. Additionally, a regression-based model is used to estimate recoveries on defaulted loans. This regression-based recovery forecast is grounded in deal-level performance data. Losses for one of the student loans deals is forecast using internal loss estimations to project transaction-level assumptions such as defaults, recoveries and prepayments based on analysis of historical experience adjusted for current economic conditions and changes to collateral composition since origination. In both approaches where collateral performance is projected, the transaction losses are incorporated into a third party waterfall model to develop loss estimates for our exposures. This waterfall model allows us to capture the impact of each transaction’s specific structure (e.g., the waterfall priority of payments, triggers, redemption priority) to generate our specific projected claims profile in various base, upside and downside scenarios.
We develop and assign probabilities to multiple cash flow scenarios based on each transaction’s unique characteristics. Probabilities assigned are based on available data related to the credit, information from contact with the issuer (if applicable), and any economic or market information that may impact the outcomes of the various scenarios being evaluated. Our base case usually projects deal performance out to maturity using expected loss assumptions. As appropriate, we also develop other cases that incorporate various upside and downside scenarios that may include changes to defaults and recoveries.
Variability of Expected Losses and Recoveries
Ambac’s management believes that the estimated future loss component of loss reserves are adequate to cover future claims presented, but there can be no assurance that the ultimate liability will not be higher than such estimates.
It is possible that our estimated future loss assumptions for insurance policies discussed above could be understated. We have attempted to identify possible cash flows using more stressful assumptions than the probability-weighted outcome recorded. The possible net cash flows consider the highest stress scenario that was utilized in the development of our probability-weighted expected loss at December 31, 2017 and assumes an inability to
execute any commutation transactions with issuers and/or investors. Such stress scenarios are developed based on management’s view about all possible outcomes. In arriving at such view, management makes considerable judgments about the possibility of various future events. Although we do not believe it is possible to have worst case outcomes in all cases, it is possible we could have worst case outcomes in some or even many cases.
Changes to assumptions that could make our reserves under-estimated include an increase in interest rates, deterioration in housing prices, poor servicing, the effect of a weakened economy characterized by growing unemployment and wage pressures, and/or illiquidity of the mortgage market. We utilize a model to project losses in our RMBS exposures and changes to reserves, either upward or downward are not unlikely if we used a different model or methodology to project losses. We regularly assess models and methodologies and may change our approach and/or model. Additionally, our R&W actual subrogation recoveries could be significantly lower than our estimate of $1,834 million as of December 31, 2017 if the sponsors of these transactions: (i) fail to honor their obligations to repurchase the mortgage loans, (ii) successfully dispute our breach findings, (iii) no longer have the financial means to fully satisfy their obligations under the transaction documents, or (iv) our pursuit of recoveries is otherwise unsuccessful.
In the case of both first and second-lien exposures, the possible stress case assumes a lower housing price appreciation projection, which in turn drives higher defaults and severities. Using this approach, the possible increase in loss reserves for RMBS credits for which we have an estimate of expected loss at December 31, 2017 could be approximately $50 million. Combined with the absence of any R&W subrogation recoveries, a possible increase in loss reserves for RMBS could be approximately $1.9 billion. Additionally, loss payments are sensitive to changes in interest rates, increasing as interest rates rise. For example an increase in interest rates of 0.50% could increase our estimate of expected losses by approximately $60 million. There can be no assurance that losses may not exceed such amounts.
Public Finance Variability:
It is possible our loss reserves for public finance credits may be under-estimated if issuers are faced with prolonged exposure to adverse political, economic, fiscal or socioeconomic events or trends.
Our experience with the city of Detroit in its bankruptcy proceeding was not favorable and renders future outcomes with other public finance issuers even more difficult to predict and may increase the risk that we may suffer losses that could be sizable. We agreed to settlements regarding our insured Detroit general obligation bonds that provide better treatment of our exposures than the city planned to include in its plan of adjustment, but nevertheless required us to incur a loss for a significant portion of our exposure. An additional troubling precedent in the Detroit case, as well as other municipal bankruptcies, is the preferential treatment of certain creditor classes, especially the public pensions. The cost of pensions and the need to address frequently sizable unfunded or underfunded pensions is often a key driver of stress for many municipalities and their related authorities, including entities to whom we have significant exposure, such as Chicago, its school
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district, the State of New Jersey and many others. Less severe treatment of pension obligations in bankruptcy may lead to worse outcomes for traditional debt creditors. In addition, cities may be more inclined to use bankruptcy to resolve their financial stresses if they believe preferred outcomes for various creditor groups can be achieved.
We expect municipal bankruptcies and defaults to continue to be challenging to project given the unique political, economic, fiscal, governance and public policy differences among municipalities as well as the complexity, long duration and relative infrequency of the cases themselves in forums with a scarcity of legal precedent.
Another potentially adverse development that could cause the loss reserves on our public finance credits to be underestimated is deterioration in the municipal bond market, resulting from reduced or no access to alternative forms of credit (such as bank loans) or other exogenous factors, such as the Tax Cuts and Jobs Act that was signed into law on December 22, 2017, which could potentially reduce municipal investor appetite for tax-exempt municipal bonds by corporate investors and over the longer term could potentially put additional pressure on issuers in states with high state and local taxes. These factors could deprive issuers access to funding at a level necessary to avoid defaulting on their obligations. While our loss reserves consider our judgment regarding issuers’ financial flexibility to adapt to adverse markets, they may not adequately capture sudden, unexpected or protracted uncertainty that adversely affects market conditions.
Our exposures to the Commonwealth of Puerto Rico are under stress arising from the Commonwealth’s poor financial condition, weak economy, loss of capital markets access and the severe damage caused by hurricanes Irma and Maria. These factors, taken together with the payment moratorium on debt payments of the Commonwealth and its instrumentalities, ongoing Puerto Rico Oversight, Management, and Economic Stability Act ("PROMESA") Title III proceedings, and certain other provisions under PROMESA, the potential for a restructuring of debt insured by Ambac Assurance, either with or without its consent, and the possibility of protracted litigation as a result of which its rights may be materially impaired, may cause losses to exceed current reserves in a material manner. See "Financial Guarantees in Force" below for further details on the legal, economic and fiscal developments that have impacted or may impact Ambac Assurance’s insured Puerto Rico bonds.
For public finance credits, including Puerto Rico as well as other issuers, for which we have an estimate of expected loss at December 31, 2017, the possible increase in loss reserves could be approximately $1.5 billion. However, there can be no assurance that losses may not exceed such amount.
Student Loan Variability:
Changes to assumptions that could make our reserves under-estimated include, but are not limited to, increases in interest rates, default rates and loss severities on the collateral due to economic or other factors. Such factors may include lower recoveries on defaulted loans or additional losses on collateral or trust assets, including as a result of any enforcement actions of the Consumer Finance Protection Bureau. For student loan credits for which we have an estimate of expected loss at December 31, 2017, the possible increase in loss reserves could be approximately $100
million. Additionally, an increase in interest rates of 0.50% could increase our estimate of expected losses by approximately $35 million. There can be no assurance that losses may not exceed such amount.
Other Credits, including Ambac UK, Variability:
It is possible our loss reserves on other types of credits, including those insured by Ambac UK, may be under-estimated because of various risks that vary widely, including the risk that we may not be able to recover or mitigate losses through our remediation processes. For all other credits, including Ambac UK, for which we have an estimate of expected loss, the sum of all the highest stress case loss scenarios is approximately $250 million greater than the loss reserves at December 31, 2017. However, there can be no assurance that losses may not exceed such amount.
Valuation of Certain Financial Instruments:
The Fair Value Measurement Topic of the ASC requires financial instruments to be classified within a three-level fair value hierarchy. The fair value hierarchy, the financial instruments classified within each level, our valuation methods, inputs, assumptions and the review and validation procedures over quoted and modeled pricing are further detailed in Note 9. Fair Value Measurements to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K.
The level of judgment in estimating fair value is largely dependent on the amount of observable market information available to fair value a financial instrument, which is also determinative of where the financial instrument is classified in the fair value hierarchy. Level 3 instruments are valued using models which use one or more significant inputs or value drivers that are unobservable and therefore require significant judgment. Level 3 financial instruments which are material include certain interest rate swaps, investments in certain Ambac-insured fixed income securities, and certain VIE assets and liabilities. Model-derived valuations of certain Level 3 financial instruments incorporate estimates of the effects of Ambac's own credit risk and/or counterparty credit risk, which can be complex and judgmental. Level 2 instruments are valued using quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in inactive markets and model-derived valuations where all the significant inputs are observable in active markets. Certain Level 2 fixed income securities that have lower trading volumes, fewer comparable securities in the market or less coverage by alternative pricing sources with reasonable levels of price transparency may require additional validation procedures and involve significant judgment.
As a result of the increased judgment for the above-described Level 3 and Level 2 instruments, the actual trade value of the financial instrument in the market, or exit value of the financial instrument owned by Ambac, may be significantly different from its recorded fair value.
Moreover, fixed income securities classified as “available-for-sale” which have experienced declines in fair value below Ambac's amortized cost must be evaluated for other-than-temporary impairment ("OTTI"). An OTTI charge is recognized if management assesses it either (i) has the intent to sell the security or (ii) more likely than not will be required to sell the security before the anticipated recovery of its amortized cost basis less any
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current period credit loss. This impairment assessment also involves determining whether an actual credit loss exists for the security. Evaluating whether declines in fair value are other-than-temporary is also inherently judgmental. For further information on the OTTI evaluation process refer to Note 2. Basis of Presentation and Significant Accounting Policies to the Consolidated Financial Statements included in Part II, Item 8 in this Form 10-K.
Valuation of Deferred Tax Assets:
Our provision for taxes is based on our income, statutory tax rates and tax planning opportunities available to us in the jurisdictions in which we operate. Tax laws are complex and subject to different interpretations by the taxpayer and respective governmental taxing authorities. Significant judgment is required in determining our tax expense and in evaluating our tax positions. We review our tax positions quarterly and adjust the balances as new information becomes available. In December 2017, H.R.1 (commonly known as the Tax Cut and Jobs Act or"TCJA") was enacted and introduced significant changes to the U.S. tax code, including to corporate tax rates, business-related exclusions, and deductions and credits effective January 1, 2018. In accordance with U.S. GAAP, the effects of changes in tax rates and laws on current and deferred tax balances must be recognized in the period in which the legislation is enacted. As such, we incorporated the effects of the TCJA in our valuation of deferred tax assets for the year ended December 31, 2017. Deferred tax assets arise because of temporary differences between the financial reporting and tax bases of assets and liabilities, as well as from net operating loss ("NOL") and tax credit carry forwards. More specifically, deferred tax assets represent a future tax benefit (or receivable) that results from losses recorded under GAAP in a current period which are only deductible for tax purposes in future periods and NOL carry forwards.
The NOL carryforward component of the deferred tax asset, which relates to NOLs generated prior to the effective date of the TCJA, will expire if not utilized within certain periods. Valuation allowances are established to reduce deferred tax assets to an amount that “more likely than not” will be realized. All available evidence, both positive and negative, needs to be identified and considered in making the determination with significant weight given to evidence that can be objectively verified. The level of deferred tax asset recognition is influenced by management’s assessment of future expected taxable income, which depends on the existence of sufficient taxable income of the appropriate character (ordinary vs. capital) within the carry forward periods available under the tax law. As a result of the risks and uncertainties associated with future operating results, management believes it is more likely than not that the Company will not generate sufficient taxable income to recover the deferred tax asset and therefore has a full valuation allowance. See Note 14. Income Taxes for additional information on the Company's deferred income taxes, including the effects of the TCJA.
FINANCIAL GUARANTEES IN FORCE
Financial guarantee products were sold in three principal markets: U.S. public finance, U.S. structured finance and international finance. The following table provides a breakdown of guaranteed net par outstanding by market sector at December 31, 2017 and 2016. Net par exposures within the U.S. public finance market include capital appreciation bonds which are reported at the par amount at the time of issuance of the insurance policy as opposed
to the current accreted value of the bonds. Guaranteed net par outstanding includes the exposures of policies that insure variable interest entities (“VIEs”) consolidated by Ambac. Guaranteed net par outstanding excludes the exposures of policies that insure bonds which have been refunded or pre-refunded:
($ in millions) December 31,
Total net par outstanding
Included in the above net par exposures at December 31, 2017 and 2016 are $326 million and $737 million, respectively, of exposures that were executed in the form of credit derivatives. See Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 8, “Financial Statements and Supplementary Data” for further discussion of credit derivative exposures.
Certain guaranteed bonds were issued as floating rate debt, including Auction Rate Securities and Variable Rate Demand Obligations, which introduces interest rate risk to Ambac Assurance. Refer to Auction Rate Securities and Variable Rate Demand Obligation Exposures below for further discussion.
U.S. Public Finance Insured Portfolio
Ambac’s portfolio of U.S. public finance exposures is $32,088 million, representing 51% of Ambac’s net par outstanding as of December 31, 2017 and a 29% reduction from the amount outstanding at December 31, 2016. This reduction in exposure was mainly due to normal exposure runoff in addition to early terminations (calls, refundings and pre-refundings). While Ambac’s U.S. public finance portfolio consists predominantly of municipal bonds such as general obligation and revenue, lease and tax-backed obligations of state and local government entities, the portfolio also comprises a wide array of non-municipal types of bonds, including financings for not-for-profit entities and transactions with public and private elements, which generally finance infrastructure, housing and other public interests. See Note 6. Financial Guarantees in Force to the Consolidated Financial Statements, included in Part II, Item 8 in this Form 10-K for exposures by bond type.
Municipal bonds are generally supported directly or indirectly by the issuer’s taxing authority or by public sector fees and assessments which may or may not be specifically pledged. Risk factors in these transactions derive from the municipal issuer, including its fiscal management, politics, and economic position, as well as its ability and willingness to continue to pay its debt service. Municipal bankruptcies and similar proceedings, while still relatively uncommon, have occurred, exposing Ambac to the risk of liquidity claims and ultimate losses if issuers cannot successfully adjust their liabilities without impairing creditors.
Not-for-profit transactions are generally supported by the not-for-profit entities’ net revenues and may also include specific pledges, liens and/or mortgages. The entity typically serves a well-defined market and promulgates a public purpose mission. These transactions may afford Ambac contractual protections such as financial covenants and control rights in the event of issuer breaches and defaults. Risk factors in these transactions derive
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from the creditworthiness of the issuer, including but not limited to, its financial condition, leverage, management, business mix, competitive position, industry and socioeconomic trends, government programs, etc. Examples of these types of transactions include not-for-profit hospitals, universities, associations and charities.
Public/private transactions are generally structured to achieve their targeted public interest objective without direct support from the public sector. Some examples of this type of financing include affordable housing, private education, and privatized military and student housing. Protections within these financings provided to Ambac usually include the strength of the financed asset’s essentiality and public purpose and may include financial covenants, collateral and control rights. Risk factors include financial underperformance, event risk and a shift in the asset’s mission or essentiality. One example of this type of financing is U.S. military housing.
Ambac insures approximately $5.8 billion net par of privatized military housing debt. The debt was issued to finance the construction and/or renovation of housing units for military personnel and their families on domestic U.S. military bases. Debt service is not directly paid or guaranteed by the U.S. Government. Rather, the bonds are serviced from the cash flow generated in most cases by rental payments deposited by the military directly into lockbox accounts as part of each service personnel’s Basic Allowance for Housing (BAH). In a small number of cases rental payments are also coming from civilians, including retired service personnel, living on a particular base. Collateral for these transactions includes the BAH payments as well as an interest in the ground lease. Risk factors affecting these transactions include ongoing base essentiality, military deployments, the U.S. government’s commitment to fund the BAH, marketability/attractiveness of the on-base housing units versus off-base housing, construction completion, environmental remediation, utility and other operating costs, and housing management.
Ambac has exposure to the Commonwealth of Puerto Rico (the "Commonwealth") and its instrumentalities across several different issuing entities. Each has its own credit risk profile attributable to discrete revenue sources, direct general obligation pledges and general obligation guarantees. Most Puerto Rico bonds insured by Ambac Assurance are not subject to acceleration. The Ambac-insured Puerto Rico Convention Center District Authority (Hotel Occupancy Tax) bonds may be accelerated only with the consent of, or at the direction of, Ambac Assurance. The Ambac-insured Puerto Rico Sales Tax Financing Corporation's Senior Sales Tax Revenue bonds may be accelerated only with the consent of Ambac Assurance, subject to the Ambac financial guaranty insurance policy being in full force and effect. Other Ambac-insured Puerto bonds are not subject to acceleration. Ambac Assurance's insurance policies do not insure against loss of any acceleration payment, other than at the sole option of Ambac.
Suspension of Debt Service Payments
In late 2015, due to the activation of the Commonwealth Constitution's Priority Debt Provision, certain revenues pledged for the repayment of debt issued by Puerto Rico Infrastructure Financing Authority (“PRIFA”), Puerto Rico Highways and
Transportation Authority (“PRHTA”) and Puerto Rico Convention Center District Authority (“PRCCDA”) were diverted by the Commonwealth to be applied to the Commonwealth's debt obligations and not applied to debt service on PRIFA, PRHTA and PRCCDA debt obligations. Consequently, a default on debt service due on certain PRIFA bonds insured by Ambac Assurance occurred on January 1, 2016.
In April 2016, the Commonwealth became subject to an emergency moratorium, known as "Law 21," on debt payments of the Commonwealth and its instrumentalities. Beginning in April 2016, and culminating on June 30, 2016, former Governor Padilla issued additional executive orders under Law 21 declaring states of emergency at PRHTA, PRIFA, PRCCDA, and other Puerto Rico instrumentalities through January 31, 2017, and suspending payment obligations on bonds issued by those entities, including bonds insured by Ambac Assurance.
On January 29, 2017, current Governor Rosselló enacted Act 5 of 2017 known as the Puerto Rico Financial Emergency and Fiscal Responsibility Act of 2017 (“Act 5”) which, among other things, established an emergency period and declared executive orders under Act 21, which suspended payments on General Obligation debt and other debt, to continue in full force and effect until amended, rescinded or superseded. On December 28, 2017, the emergency period was extended to June 30, 2018 by Executive Order 2017-76.
On June 30, 2016, the Puerto Rico Oversight, Management, and Economic Stability Act ("PROMESA") was signed into law by the President of the United States. PROMESA establishes a seven-member federal financial oversight board (“Oversight Board”) with authority to require that balanced budgets and fiscal plans be adopted and implemented by Puerto Rico. PROMESA provides a legal framework under which the debt of the Commonwealth and its related authorities and public corporations may be voluntarily restructured, and grants the Oversight Board the sole authority to file restructuring petitions in a federal court to restructure the debt of the Commonwealth and its related authorities and public corporations if voluntary negotiations fail, provided that any such restructuring must be in accordance with an Oversight Board approved fiscal plan that respects the liens and priorities provided under Puerto Rico law.
PROMESA provides that laws such as Act 21 are not binding on any non-consenting creditor to the extent they prohibit the payment of principal or interest. The practical effect of this provision is unknown and therefore Ambac is at risk to the ongoing execution, interpretation and ultimate enforcement of this provision. PROMESA also provides that unlawful executive orders are preempted under PROMESA, but there is no procedure for determining whether a particular executive order is unlawful, creating uncertainty in general and with specific regards to how the preemption provision will be implemented towards Ambac’s exposures.
PROMESA is untested and many provisions are unique. There is inherent uncertainty and risk both generally and for Ambac’s exposures specifically regarding the interpretation and implementation of PROMESA. Among other things, PROMESA contains provisions that may permit consensual and non-
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consensual restructurings of debt obligations of the Commonwealth and its instrumentalities.
The following table shows Ambac's insured exposure to each issuer segregated by whether such debt obligation is subject to the Priority Debt Provision or "clawback." Ambac has initiated litigation challenging the application of the "clawback" announced by
Governor Padilla, Puerto Rico's former governor, on December 1, 2015. A description of Ambac's legal challenge is provided in Note 16. Commitments and Contingencies in the Consolidated Financial Statements, included in Part II, Item 8 in this Form 10-K.
($ in millions)
Range of Maturity
Net Par and Interest Outstanding (3)(8)
Ever-to-Date Net Claims Paid(4)
Exposures Subject to Priority Debt Provision (5)
PR Highways and Transportation Authority (1968 Resolution - Highway Revenue) (6)
PR Highways and Transportation Authority (1998 Resolution - Senior Lien Transportation Revenue) (6)
PR Infrastructure Financing Authority (Special Tax Revenue) (7)
PR Convention Center District Authority (Hotel Occupancy Tax)
Exposures Not Subject to Priority Debt Provision
Commonwealth of Puerto Rico - General Obligation Bonds
PR Public Buildings Authority - Guaranteed by the Commonwealth of Puerto Rico
PR Sales Tax Financing Corporation - Senior Sales Tax Revenue (COFINA)
Total Net Exposure to The Commonwealth of Puerto Rico and Related Entities
Internal credit ratings are provided solely to indicate the underlying credit quality of guaranteed obligations based on the view of Ambac Assurance. In cases where Ambac Assurance has insured multiple tranches of an issue with varying internal ratings, or more than one obligation of an issuer with varying internal ratings, a weighted average rating is used. Ambac Assurance credit ratings are subject to revision at any time and do not constitute investment advice. BIG denotes credits deemed below investment grade.
Net Par includes capital appreciation bonds, which are reported at the par amount at the time of issuance of the insurance policy as opposed to the current accreted value of the bonds. Accretion of the capital appreciation bonds would increase the related net par by $683 million at December 31, 2017.
Net Par and Interest Outstanding ("P&I") represents the total insured future debt service remaining over the lifetime of the bonds. P&I for capital appreciation bonds does not represent the accreted amount as noted in footnote (2) but rather the amount due at respective maturity dates.
In addition to ever-to-date net claims paid, Ambac made net claim payments of $26 million during January 2018.
Commonly known as "clawback" provision pursuant to Section 8 of Article VI of the Constitution of the Commonwealth of Puerto Rico. Under this provision, in case the available revenues (the Spanish version uses the term “resources”) including surplus for any fiscal year are insufficient to meet the appropriations made for that year, interest on the public debt and amortization thereof shall first be paid, and other disbursements shall thereafter be made in accordance with the order of priorities established by law. These exposures are also subject to Act No. 5-2017, as amended, also known as the Financial Emergency and Fiscal Responsibility Act of 2017, which declares an emergency period that has been subsequently extended until June 30, 2018. Pursuant to Act 5-2017, all executive orders issued under Act No. 21-2016 (as amended, known as the Puerto Rico Emergency Moratorium and Financial Rehabilitation Act), shall continue in full force and effect until amended, rescinded or superseded.
Certain Pledged Revenues for Highways and Transportation Revenue Bonds such as Toll Revenues and Investment Earnings are not subject to the Priority Debt Provision.
Payable from and secured by proceeds from a federal excise tax imposed on all items produced in Puerto Rico and sold on the mainland of the United States. Currently, rum is the only product from Puerto Rico subject to this federal excise tax.
Net Par and Interest Outstanding excludes the effects of a 10% current interest rate on $60 million net par of PR Public Building Authority ("PBA") bonds with a maturity date of July 1, 2035, resulting from the absence of a remarketing. Should a remarketing not occur before the maturity of the bonds, the Net Par and Interest Outstanding for PBA exposure would increase by $47.4 million.
PROMESA also confers significant powers and responsibilities on the Oversight Board. Among other things, the Oversight Board is required to certify any insolvency petitions that may be filed by Puerto Rico or its instrumentalities under Title III of PROMESA, any proposed plans of adjustment in such proceedings, and any voluntary restructuring agreement among creditors under Title VI of PROMESA (which has the potential to bind non-consenting creditors). The Oversight Board is also required to approve fiscal plans and budgets
submitted by the Commonwealth and monitor compliance with those plans and budgets, and to approve any debt issuances or modifications by the Commonwealth or its instrumentalities. Ambac is unable to predict to what extent debt restructurings will be proposed or implemented under PROMESA, and how its insured obligations will fare in any such restructurings.
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Title III Filings
In response to letter requests from Governor Rosselló, the Oversight Board commenced a PROMESA Title III proceeding, which is a proceeding for adjustments of debt, for the Commonwealth of Puerto Rico on May 3, 2017, and for the Puerto Rico Sales Tax Financing Corporation ("COFINA") on May 5, 2017, in the United States District Court for the District of Puerto Rico. Subsequently, the Oversight Board commenced a Title III proceeding for the Employees Retirement System ("ERS") and PRHTA on May 21, 2017, and for the Puerto Rico Electric Power Authority ("PREPA") on July 2, 2017. Ambac Assurance has not issued any financial guaranty policies with respect to obligations of ERS or PREPA.
On March 13, 2017, the Oversight Board certified the 10-year Fiscal and Economic Growth Plan ("FEGP") for the Commonwealth. The certified FEGP, among other things, was intended to provide Commonwealth creditors a base from which to progress consensual negotiations under Title VI of PROMESA. However, the certified FEGP implied a 77% discount to all debt service due to be paid by the Commonwealth and its instrumentalities covered by the FEGP over the ten-years of the plan (FY2017-2026). The FEGP did not provide details regarding its underlying assumptions and data, expense definitions, cause of expense growth or accounting adjustments and did not include any restructuring proposals. These deficiencies of the FEGP, when combined with the absence of sufficient projected cash flows for debt service, increased the uncertainty of whether successful consensual negotiations can be reached or what creditor outcomes might be under the Title III proceedings.
As a result of the damage inflicted by Hurricane Maria in September 2017, the anticipated influx of certain federal funds, and other structural changes following the hurricane, the Commonwealth drafted revised fiscal and economic growth plans (the “Revised FEGPs”) for the Commonwealth and various instrumentalities. On January 24, 2018, the Puerto Rico Fiscal Agency and Financial Advisory Authority (“FAFAA”) released the proposed Revised FEGPs for the Commonwealth, PREPA and Puerto Rico Aqueduct and Sewer Authority (“PRASA”). The proposed Revised FEGPs were also submitted to the Oversight Board for review and certification. On February 5, 2018, the Oversight Board issued a notice of violation with respect to each of these Revised FEGPs. In the notice of violation for the Revised FEGP for the Commonwealth, the Oversight Board required a more detailed debt sustainability analysis over a 30-year period, among other changes. The required changes and further clarifications to the Commonwealth, PREPA, and PRASA FEGPs were submitted to the Oversight Board on February 12, 2018. Subsequent review and certification by the Oversight Board is intended to be complete by March 30, 2018.
The Commonwealth’s proposed Revised FEGP submitted on February 12, 2018, uses a six-year horizon, projects a six-year cumulative decline in population of 20.0%, cumulative nominal GNP growth of 16.7%, cumulative revenue growth of 3.1%, and projects that by the Commonwealth's fiscal year 2023 there will be an accumulated surplus of $3.4 billion. However, this proposed Revised FEGP does not delineate expenses between essential and non-essential services, does not define essential services, and does not provide for any cash flows for debt service. This proposed
Revised FEGP also does not address permanent debt write-downs and the extent of longer-term debt service, leaving uncertainty about the Commonwealth’s future obligations.
If certified without meaningful changes from the current proposed plans, the Revised FEGPs of the Commonwealth, PREPA, and PRASA could perpetuate the uncertainty around the potential timing and severity of any permanent losses on Ambac-insured bonds of the Commonwealth and its instrumentalities and may lead to further protracted resolution timelines between creditors and debtors. Furthermore, if the Revised FEGPs, without meaningful changes, became the sole or primary measure for determining creditor outcomes, Ambac's financial condition, including liquidity, loss reserves and capital resources may suffer a materially negative impact.
The proposed Revised FEGPs for the Government Development Bank, the University of Puerto Rico, PRHTA and the COSSEC (the savings and loan cooperatives regulators) are due to be submitted March 9, 2018, which the Oversight Board intends to review and certify by April 20, 2018. It is currently unclear what, if anything, the revised fiscal plan for PRHTA will do to address the restructuring of its debt obligations. However, any such restructuring proposal may include material cuts to payment of principal and interest on outstanding bonds of PRHTA, including bonds insured by Ambac Assurance.
Hurricanes Irma and Maria
On September 6, 2017, Hurricane Irma, a Category 5 storm, passed north of Puerto Rico leaving more than 1 million people without electricity on the island. On September 20, 2017, Hurricane Maria, a Category 4 storm at the time, made landfall in Puerto Rico, causing severe damage to the island and its infrastructure, including the destruction of a significant portion of the the electrical transmission and distribution system on the the island. The extensive damage and the disruption to the economy caused by the hurricanes further stressed what was already a challenging position for the Commonwealth highlighted by: (i) existing poor economic and demographic trends, including fluctuating economic activity levels and continued outmigration, (ii) weak debt and contingent liability position, including unsustainable leverage and high fixed costs for pensions; (iii) historically weak budgetary performance and flexibility (Fiscal Year 2016 and prior structural imbalances); and (iv) uncertain financial and economic prospects. For at least the near-term, the Commonwealth faces uncertain financial and economic prospects due to the scale of the damage from the hurricanes as well as the uncertainty over the total amount, timing, and impact of Federal aid for disaster recovery.
On November 13, 2017, Governor Rosello submitted a formal request for Federal disaster relief assistance of $94.4 billion to help the Commonwealth recover and rebuild from hurricanes Irma and Maria. It is unclear at this time how much of Governor Rosello's request or in what form will ultimately be made available to assist Puerto Rico.
To date, $4.9 billion is being made available to Puerto Rico and the U.S. Virgin Islands as a Community Development Loan ("CDL") as part of a $36.5 billion disaster aid bill signed into law on October 26, 2017. In addition, the Federal Emergency Management Agency ("FEMA") reported that in the last three
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months of 2017, its obligations under the Disaster Recovery Funds ("DRF") program for Puerto Rico for hurricanes Irma and Maria totaled $6.7 billion with another $7.0 billion estimated for the nine months ending September 30, 2018.
On February 9, 2018, the Bipartisan Budget Act of 2018 was signed into law. There were several elements of this legislation that were targeted to assist in the recovery of Puerto Rico, including $4.8 billion in Medicaid funding for two years; $11 billion for the U.S. Housing and Urban Development's Community Development Block Grant Disaster Relief program for housing, infrastructure and economic development; additional funding for FEMA's DRF program; and other disaster aid measures. In addition, the legislation provides for an extension to 2022 of the rum excise tax cover-over that provides increased rum tax rebates for Puerto Rico, extends by one year deductions allowable with respect to income attributable to domestic production activities in Puerto Rico under U.S. Code Section 199, and also adds each low-income community in Puerto Rico to be designated as a qualified opportunity zone under Sec. 1400Z-1, which allows those areas to qualify for certain tax incentives. The total value of all of the Puerto Rico-specific elements of the legislation is unclear at this time and it is possible that additional Federal aid packages may be approved during the course of 2018.
See Item 1A. Risk Factors
The publishing on January 19, 2018, by FAFAA of an updated report on $6.8 billion of cash balances and the classification of approximately 800 bank accounts originally addressed in FAFAA’s initial December 18, 2017 report did not appear to provide for any enhanced liquidity for the Commonwealth and its instrumentalities, as the report claimed that much of this balance had restricted uses or was tied up in ongoing litigation. Consequently, this purported lack of access to a portion of these funds could exacerbate existing liquidity constraints of the Commonwealth and its instrumentalities for certain essential and non-essential services and further strain timelines and potential severities for creditors, including Ambac. In connection with the report, the Oversight Board confirmed that it appointed an independent forensic analysis team to compile a comprehensive inventory of all government bank accounts, cash equivalents, and investments along with their respective account balances.
On June 14, 2017, Judge Laura Taylor Swain entered an order appointing a team of mediators to facilitate confidential mediation discussions in order to facilitate consensual resolution of certain issues arising in the context of these Title III cases. The mediation team is led by Chief Judge Barbara Houser of the United States Bankruptcy Court for the Northern District of Texas, and consists of Circuit Judge Thomas Ambro of the United States Court of Appeals for the Third Circuit, Senior District Judge Nancy Atlas of the United States District Court for the Southern District of Texas, Bankruptcy Judge Christopher Klein of the United States Bankruptcy Court for the Eastern District of California, and Senior District Judge Victor Marrero of the United States District Court for the Southern District of New York. Confidential mediation proceedings are ongoing. No assurances can be given that consensual resolutions will be achieved with respect to the
Commonwealth’s or COFINA’s obligations or those of any other Puerto Rico instrumentality.
Ambac Post-Title III Litigation Update
Ambac Assurance is party to ten litigations related to its Puerto Rico exposures. Six of these litigations are stayed under Title III of PROMESA, and one has been stayed by order of the United States District Court for the District of Puerto Rico pending resolution of an interpleader action related to COFINA funds (to which interpleader action Ambac is also a party). The three active litigations are proceeding as adversary proceedings under the Title III process before the United States District Court for the District of Puerto Rico. Accordingly, Ambac is unable to predict when and how the issues raised in those cases will be resolved. If Ambac Assurance is unsuccessful with any of these challenges, Ambac’s financial condition, including liquidity, loss reserves and capital resources may suffer a material negative impact.
Refer to Note 16. Commitments and Contingencies included in Part II, Item 8 in this Form 10-K for further information about Ambac's litigation relating to Puerto Rico.
Other Post-Title III Litigation Update
On January 30, 2018, the United States District Court for the District of Puerto Rico issued two decisions in adversary proceedings related to the Title III restructuring of the Commonwealth of Puerto Rico and certain of its instrumentalities.
In Assured Guaranty Corp., et al. v. Commonwealth of Puerto Rico, et al. (No. 17-155), the court dismissed the plaintiff monoline insurers’ complaint against the Commonwealth and the PRHTA (among other defendants). The court ruled that the special revenues provisions of the Bankruptcy Code do not require a debtor, post-petition, to apply the special revenues to the bonds they secure. The court also held that the plaintiffs were unable to show that bondholders have an ownership interest, to the exclusion of PRHTA, in the funds held in certain reserve accounts at PRHTA. The court rejected the Commonwealth and Oversight Board’s argument that Section 305 of PROMESA, a provision that reserves the right of the Title III debtor to control its own governmental powers and property, deprives the court of jurisdiction over certain claims; instead, the court held that section 305 only limits the court’s ability to order remedies that would interfere with the debtor’s governmental powers or ability to control its property. The court did not address whether the PRHTA bonds are secured by a lien or security interest. Ambac Assurance brought similar claims (among others) in Ambac Assurance Corporation v. Puerto Rico, et al. (No. 1:17-ap-00159). The court has not yet ruled on Ambac Assurance’s claims, but in light of its decision in the Assured case, there is a substantial risk that the court will dismiss such claims for the same reasons it dismissed the complaint of the monoline insurers in Assured.
In ACP Master, Ltd., et al. v. Commonwealth of Puerto Rico, et al. (No. 17-189), the court dismissed the plaintiff general obligation (“GO”) bondholders’ complaint against the Commonwealth and the Oversight Board. The court held that the GO bondholders’ effort to compel application of certain revenues to the payment of GO bonds was barred by section 305 of PROMESA, as this ruling would interfere with the governmental powers of the debtor (the Commonwealth). The court further held that the remaining counts of the plaintiffs’ complaint, which requested declarations as to the
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legal status of the GO bonds could not be adjudicated because they sought advisory opinions and therefore were not justiciable.
The court’s decisions that section 305 of PROMESA restricts the court’s ability to order remedies that would interfere with the debtor’s governmental powers or ability to control its property, if not overturned on appeal, likely will limit the ability of Ambac Assurance to successfully compel the payment of debt service on its insured obligations during the pendency of the Title III cases and may adversely impact the proposed terms applicable to such obligations under any plan of adjustment proposed in Title III proceedings. Any such proposed plan of adjustment would, however, need to satisfy the requirements of PROMESA, including consistency with certified fiscal plans, which are required to respect lawful priorities or lawful liens, in order to be approved by the court.
Accordingly, Ambac Assurance is unable to predict when and how the issues raised in its cases will be resolved ultimately. If Ambac Assurance is unsuccessful with any of its challenges, its financial condition, including liquidity, loss reserves and capital resources, may suffer a material negative impact.
As a result of the developments described in this 10-K, the Commonwealth of Puerto Rico and certain of its instrumentalities will continue to default on debt service payments, including payments owed on bonds insured by Ambac Assurance. Ambac Assurance may be required to make significant amounts of policy payments over the next several years, the recoverability of which is subject to great uncertainty, which may lead to material permanent losses. Our exposure to Puerto Rico is impacted by the amount of monies available for debt service, which is in turn affected by variability in economic growth, tax revenues, essential services expense as well as federal funding of Commonwealth needs. In addition, our exposure to Puerto Rico is impacted by the significant damage to the Commonwealth that was inflicted by Hurricane Maria, which made landfall on September 20, 2017, as well as Hurricane Irma, which passed just north of the island on September 6, 2017. The longer term recovery of the economy of the Commonwealth and its essential infrastructure will likely be highly dependent on the amount, timing and effectiveness of Federal aid. There is historical precedent for meaningful Federal support following other natural disasters in the United States and its territories and, to date, some Federal aid measures have been approved and have already started to assist in the recovery. However, there can be no assurances as to the sufficiency or ultimate level of the aid and as to the effectiveness of the deployment of the aid in benefiting the long term recovery of economic activity in Puerto Rico. While our reserving scenarios
reflect a wide range of possible outcomes reflecting the significant uncertainty regarding future developments and outcomes, given our exposure to Puerto Rico and the economic, fiscal, legal and political uncertainties associated therewith as well as the uncertainties emanating from the damage caused by hurricanes Maria and Irma, our loss reserves may ultimately prove to be insufficient to cover our losses, potentially by a material amount, and may be subject to material volatility.
Given the numerous uncertainties existing with respect to the restructuring process and relevant litigations, no assurance can be given that ultimate debt service discounts will not be severe and cause Ambac to experience losses materially exceeding current reserves. It is possible that certain restructuring process solutions, together with associated legislation, budgetary, and/or public policy proposals could be adopted and could further impair our exposures. In addition, there are possible final legal determinations, including failing to recognize or properly differentiate legal structures and protections applicable to such exposures, that could result in losses exceeding our current reserves by a material amount and our loss reserves would need to be increased. In particular, in a Title III process, should court-approved plans of adjustment for the Commonwealth, COFINA, PRHTA, or any other issuers of Ambac-insured debt that file for Title III protection imply further discounts to debt service than under the Commonwealth’s Revised FEGP, the Fiscal Plan Compliance Act be upheld, or Ambac receive unfavorable judgments in the litigations to which it is a party, Ambac’s financial condition could be materially adversely affected. It is also possible that economic or demographic outcomes may be worse than forecast under the Commonwealth’s revised FEGP or under proposals or plans promulgated by the Commonwealth or its instrumentalities in or in connection with a Title III process or otherwise. Even a negotiated restructuring to which Ambac agrees as part of a Title VI or other process may involve material losses in excess of current reserves.
Ambac has considered these developments and other factors in evaluating its Puerto Rico loss reserves. During the year ended December 31, 2017, Ambac had incurred losses associated with its Domestic Public Finance insured portfolio of $476.3 million, which was significantly impacted by the continued uncertainty and volatility of the situation in Puerto Rico. While management believes its reserves are adequate to cover losses in its Public Finance insured portfolio, there can be no assurance that Ambac may not incur additional losses in the future, particularly given the developing economic, political, and legal circumstances in Puerto Rico. Such additional losses may have a material adverse effect on Ambac’s results of operations and financial condition.
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The table below shows Ambac’s ten largest U.S. public finance exposures, by repayment source, as a percentage of total financial guarantee net par outstanding at December 31, 2017:
($ in millions)
% of Total
New Jersey Transportation Trust Fund Authority - Transportation System
Puerto Rico Sales Tax Financing Corporation - Senior Sales Tax Revenue (COFINA)
Massachusetts Commonwealth - GO
Mets Queens Baseball Stadium Project, NY, Lease Revenue
Hickam Community Housing LLC
Chicago, IL - GO
Puerto Rico Infrastructure Financing Authority, Special Tax Revenue
Puerto Rico Highways & Transportation Authority, Transportation Revenue
Bragg Communities, LLC
New Jersey Economic Development Authority - School Facilities Construction
Internal credit ratings are provided solely to indicate the underlying credit quality of guaranteed obligations based on the view of Ambac Assurance. In cases where Ambac Assurance has insured multiple tranches of an issue with varying internal ratings, or more than one obligation of an issuer with varying internal ratings, a weighted average rating is used. Ambac Assurance credit ratings are subject to revision at any time and do not constitute investment advice. BIG denotes credits deemed below investment grade.
Net Par includes capital appreciation bonds, which are reported at the par amount at the time of issuance of the insurance policy as opposed to the current accreted value of the bonds.
U.S. Structured Finance Portfolio
Ambac’s portfolio of U.S. structured finance exposures is $13,816 million, representing 22% of Ambac’s net par outstanding as of December 31, 2017, and an 18% reduction from the amount outstanding at December 31, 2016. This reduction in exposure was primarily related to residential mortgage-backed policies, including commutations and other de-risking initiatives on certain residential mortgage-backed policies.
Insured exposures include securitizations of mortgage loans, home equity loans, student loans, leases, operating assets, collateralized debt obligations ("CDO"), collateralized loan obligations (“CLO”), and other asset-backed financings, in each case where the majority of the underlying collateral risk is situated in the United States. Included within the lease securitization sector are pooled aircraft and rail car transactions. Additionally, Ambac’s structured finance insured portfolio includes secured and unsecured debt issued by investor-owned utilities, structured insurance transactions and aircraft equipment trust certificates. See Note 6. Financial Guarantees in Force to the Consolidated Financial Statements, included in Part II, Item 8 included in this Form 10-K, for exposures by bond type as of December 31, 2017.
Structured finance exposures generally entail three forms of risk: (i) asset risk, which relates to the amount and quality of the underlying assets; (ii) structural risk, which relates to the extent to which the transaction’s legal structure and credit support provide protection from loss; and (iii) servicer risk, which is the risk that
poor performance at the servicer or manager level contributes to a decline in cash flow available to the transaction. Ambac Assurance seeks to mitigate and manage these risks through its risk management practices.
Structured securities are usually designed to help protect the investors and, therefore, the guarantor from the bankruptcy or insolvency of the entity that originated the underlying assets as well as from the bankruptcy or insolvency of the servicer of those assets. The servicer of the assets is typically responsible for collecting cash payments on the underlying assets and forwarding such payments, net of servicing fees, to a trustee for the benefit of the issuer. One potential issue is whether the sale of the assets by the originator to the issuer would be upheld in the event of the bankruptcy or insolvency of the originator and whether the servicer of the assets may be permitted or stayed from remitting to investors cash collections held by it or received by it after the servicer or the originator becomes subject to bankruptcy or insolvency proceedings. Another potential issue is whether the originator sold ineligible assets to the securitization transaction that subsequently deteriorated, and, if so, whether the originator has the willingness or financial wherewithal to meet its contractual obligations to repurchase those assets out of the transaction. Structural protection in a transaction, such as control rights that are typically held by the senior note holders, or guarantor in insured transactions, will determine the extent to which underlying asset performance can be influenced upon non-performance to improve the revenues available to cover debt service.
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The following table presents the top five servicers by net par outstanding at December 31, 2017, for U.S. structured finance exposures:
($ in millions)
% of Total
Specialized Loan Servicing, LLC
Bank of America N.A.
Wells Fargo Bank
Pennsylvania Higher Education Assistance Agency
Ocwen Loan Servicing, LLC
The table below shows Ambac’s ten largest structured finance transactions, as a percentage of total financial guarantee net par outstanding at December 31, 2017:
($ in millions)
% of Total
Ballantyne Re Plc (2)
Progress Energy Carolinas, Inc.
Investor Owned Utility
Wachovia Asset Securitization Issuance II, LLC 2007-HE2
Mortgage Backed Securities
Timberlake Financial, LLC
Wachovia Asset Securitization Issuance II, LLC 2007-HE1
Mortgage Backed Securities
Consolidated Edison Company of New York
Investor Owned Utility
Option One Mortgage Loan Trust 2007-FXD1
Mortgage Backed Securities
CenterPoint Energy Inc.
Investor Owned Utility
Niagara Mohawk Power Corporation
Investor Owned Utility
Duke Energy Ohio, Inc.
Investor Owned Utility
Internal credit ratings are provided solely to indicate the underlying credit quality of guaranteed obligations based on the view of Ambac Assurance, and for Ambac UK related transactions, based on the view of Ambac UK. In cases where Ambac Assurance or Ambac UK has insured multiple tranches of an issue with varying internal ratings, or more than one obligation of an issuer with varying internal ratings, a weighted average rating is used. Ambac Assurance and Ambac UK credit ratings are subject to revision at any time and do not constitute investment advice. BIG denotes credits deemed below investment grade.
Insurance policy issued by Ambac UK.
International Finance Insured Portfolio
Ambac’s portfolio of international finance insured exposures is $16,812 million, representing 27% of Ambac’s net par outstanding as of December 31, 2017 and a 3% reduction from the amount outstanding at December 31, 2016. This reduction in exposure was primarily the result of policy terminations within investor-owned utilities and asset-backed securities partially offset by the weakening of the US dollar. Ambac’s international finance insured exposures include a wide array of obligations in the international markets, including infrastructure financings, asset-securitizations, utility obligations and whole business securitizations (e.g., securitizations of substantially all of the operating assets of a corporation). Ambac has no insured exposure related to emerging markets. See Note 6. Financial Guarantees in Force to the Consolidated Financial Statements, included in Part II, Item 8 included in this Form 10-K, for exposures by bond type as of December 31, 2017.
When underwriting transactions in the international markets, Ambac considered the specific risks related to the particular country and region that could impact the credit of the issuer. These risks include the legal and political environment, capital markets dynamics, foreign exchange issues and the degree of governmental support. Ambac continues to assess these risks through its ongoing risk management.
Ambac UK, which is regulated in the United Kingdom (“UK”), had been Ambac Assurance’s primary vehicle for directly issuing financial guarantee policies in the UK and the European Union with $15,881 million net par outstanding in those markets at December 31, 2017. The portfolio of insured exposures underwritten by Ambac UK is financially supported exclusively by the assets of Ambac UK and no capital support arrangements are in place with any other Ambac affiliate.
Other European Union Exposures (“EU”)
Ambac's international exposures are principally in the United Kingdom; however, we also have exposures with credit risk based in various other EU member states, including Austria, France, Germany, Italy and Spain. Several of these countries have experienced significant economic, fiscal and/or political strains such that the likelihood of default on such obligations is higher than when the policies were underwritten. The Company’s exposures, net of reinsurance, to these countries are shown in the following table:
| Ambac Financial Group, Inc. 44 2017 FORM 10-K |
($ in millions)
Infrastructure / operating asset backed
Total below investment grade
Ambac does not guarantee any sovereign bonds of the above EU countries. However, the exposures classified as sub-sovereign may be impacted should there be adverse financial developments in the EU. Those exposures classified as infrastructure/operating asset backed are concession based where the underlying assets independently generate cash flow without operational reliance on the sovereign. Of the below investment grade exposures, the investor-owned utilities (wind farm and mini hydro-electric plant) are either undergoing restructuring processes designed to address their performance issues (in the case of mini hydro-electric plant) or have already been the subject of restructuring processes to mitigate performance issues (wind farm). The other below investment grade exposure is a road transaction, where performance has been poorer than anticipated due to lower than forecast traffic volumes, however, performance is improving. Below investment grade is defined as those exposures with a credit rating below BBB-.
In a non-binding referendum on the United Kingdom’s (“UK”) membership in the European Union (“EU”) in June 2016, a majority of those who voted approved the UK’s withdrawal from the EU. As a result of the referendum, in March 2017 the UK government gave the EU formal notification of its intent to leave with the expectation of a formal withdrawal two years later on March 29, 2019. Also, in March 2017 the UK began initial (or phase one) negotiations with the EU regarding the terms of its departure (“Brexit”). On December 8, 2017, the EU and UK jointly announced, as set out in the Joint Report and Commission Communication of 8 December (“Joint Report”), that “sufficient progress” in phase one of the separation negotiations between the
parties had been made to permit Brexit negotiations to move on to a more detailed phase two beginning in January 2018.
If no transitional arrangements or new agreement are put into place, Brexit will mean that the activities in the EEA of UK passporting insurers will become unlawful on March 29, 2019. They will lose their legal authorization to serve clients who benefit from policies issued by a UK incorporated insurer under freedom of services passporting rights (and thereby maybe unable to legally collect premiums or pay claims) and if they have branches in EEA Member States they may be legally obliged to close them down and no longer be legally represented in those jurisdictions.
In addition to the direct impact on insurers cited above, general uncertainty and the perceptions as to the ultimate impact of Brexit may adversely affect business activity, political stability and economic conditions in the UK, the Eurozone, the EU and elsewhere. The economic outlook could be further adversely affected by (i) the risk that one or more other EU countries could come under increasing pressure to leave the EU, (ii) the risk of a greater demand for independence by Scottish nationalists or for unification in Ireland and its impact on the United Kingdom, or (iii) the risk that the Euro as the single currency of the Eurozone could cease to exist. Any of these developments, or the perception that any of these developments are likely to occur, could have a material adverse effect on economic growth or business activity in the UK, the Eurozone, and/or the EU, and could result in the relocation of businesses, cause business interruptions, lead to economic recession or depression, and impact the stability of the financial markets, the availability of credit, political systems or financial institutions and the financial and monetary system.
The table below shows our ten largest international finance transactions as a percentage of total financial guarantee net par outstanding at December 31, 2017. Except where noted, all international finance transactions included in the table below are insured by Ambac UK:
($ in millions)
% of Total
Mitchells & Butlers Finance plc-UK Pub Securitisation
National Grid Electricity Transmission
Aspire Defence Finance plc